SERVICE PROVIDES EXTENSIVE GUIDANCE FOR LONG-TERM CONTRACT ACCOUNTING.

Notice 89-15

This notice provides guidance with respect to section 460 of the Internal Revenue Code, relating to the accounting for long-term contracts.

I. BACKGROUND

Section 804 of the Tax Reform Act of 1986, Pub. L. No. 99-514 (the "1986 Act"), added section 460 to the Internal Revenue Code, effective for contracts entered into after February 28, 1986. Section 10203 of the Revenue Act of 1987, Pub. L. No. 100-203 (the "1987 Act"), amended section 460, effective for contracts entered into after October 13, 1987 (except for certain ship contracts described in section 10203(b)(2) of the 1987 Act). Section 5041 of the Technical and Miscellaneous Revenue Act of 1988, Pub. L. No. 100-647 (the "1988 Act") further amended section 460, effective for contracts entered into after June 20, 1988 (except for certain ship contracts, as provided in section 5041(e)(1)(C) of the 1988 Act). The Questions and Answers in this notice discuss general rules under section 460, changes to section 460 made by the 1988 Act, and transitional rules under the 1988 Act. Previous guidance concerning section 460 was provided in Notice 87-61, 1987-2 C.B. 370, and Notice 88-66, 1988-25 I.R.B. 41.

Rules for determining whether a contract is a long-term contract within the meaning of section 460 are set forth in Q&A-2 through Q&A- 8. The effective date of section 460 is discussed in Q&A-9 through Q&A-13. Rules for determining which of the two long-term contract methods must be used by a taxpayer are set forth in Q&A-14. Rules for applying the percentage of completion-capitalized cost method are set forth in Q&A-15 through Q&A-18. Question 17 addresses the application of the percentage of completion-capitalized cost method by a taxpayer using a LIFO method of valuing inventories. Rules for applying the percentage of completion method are set forth in Q&A-19 through Q&A- 36. Q&A-37 and Q&A-38 address the rules that apply to severing and aggregating contracts. Rules for determining which costs are allocable to a long-term contract, and therefore taken into account under section 460, are set forth in Q&A-39 and Q&A-40. The exceptions applicable to certain construction contracts provided by section 460(e) are explained in Q&A-41 through Q&A-46. Rules governing changes in methods of accounting under section 460 are set forth in Q&A-7, Q&A-13, and Q&A-47 through Q&A-49.

The Internal Revenue Service expects to issue separate guidance relating to the look-back method of section 940(b). This notice does not address the look-back method. See Form 8697 and its instructions.

II. PERMISSIBLE METHODS OF ACCOUNTING FOR LONG-TERM CONTRACTS

Q-1: Under section 460 of the Internal Revenue Code, what methods of accounting are to be used for items of income from and costs allocable to long-term contracts?

A-1: With the exception of certain construction contracts (including certain home construction contracts entered into after June 20, 1988) described in section 460(e)(1) (see Q&A-42 through Q&A-44), section 460(a) requires that items of income from and costs allocable to a long-term contract be taken into account under either of two methods of accounting: (1) the percentage of completion method, or (2) the percentage of completion-capitalized cost method. Rules for determining which of these two methods must be used by a taxpayer are set forth in Q&A-14.

III. DEFINITION OF LONG-TERM CONTRACT

Q-2: What is a long-term contract for purposes of section 460?

A-2: In general, under section 460(f), a long-term contract is any contract for the manufacture, building, installation, or construction of property if the contract is not completed within the taxable year in which it is entered into. A contract for the manufacture of property, however, is not treated as a long-term contract unless certain additional conditions set forth in section 460(f)(2) (and explained in Q&A-5) are met. For these purposes, a contract for the production of personal property is generally considered to be a contract for the manufacture of property. In contrast, any contract for the production or installation of real property or any improvements to real property, is considered to be a contract for the building, installation, or construction of property.

In determining whether a contract is completed in the taxable year in which it is entered into, all activities of the taxpayer and any related parties in connection with the manufacture, building, installation, or construction must be taken into account. For additional rules applicable to related parties, see Q&A-8.

Q-3: In determining whether a contract is a long-term contract, is it relevant that the taxpayer reasonably believed at the time that the contract was entered into that it would be completed within the same taxable year?

A-3: No. A contract that satisfies the definition of a long-term contract set forth in Q&A-2 is considered a long-term contract even though the taxpayer expected that it would be completed within the taxable year.

Q-4: Is a contract considered to be for the "manufacture, building, installation, or construction of property," even though the contract provides that the contractor is to retain title to, control over, and risk of loss with respect to the property until it is completed and accepted by the customer, and even though the parties characterize the contract as a contract for the sale of property?

A-4: Such a contract is considered to be for the "manufacture, building, installation, or construction of property," if the manufacture, building, installation, or construction of the subject matter of the contract is necessary in order for the taxpayer's contractual obligations to be fulfilled, and if the manufacture, building, installation or construction has not been completed at the time that the contract is entered into. It is not relevant whether the customer has title to control over, or risk of loss with respect to the property. Moreover, it is not relevant whether the parties characterize their agreement as a contract for the sale of property.

EXAMPLE (1). Y notifies X, an aircraft manufacturer, that it wishes to purchase an aircraft of a particular type. At the time X receives the order, X has on hand several partially completed aircraft of this type; however, X does not have any completed aircraft of this type on hand. X and Y agree that Y will purchase one of these aircraft after it has been completed. X retains title to and risk of loss with respect to the aircraft until the sale takes place. The agreement between X and Y is a contract for the manufacture of property within the meaning of section 460(f)(1), even if characterized by the parties as a contract for the sale of property. (See Q&A-5 for additional conditions that must be met in order for a contract for the manufacture of property to be a long-term contract.)

EXAMPLE (2). A, a calendar year builder with average annual gross receipts of more than $10 million, begins construction of a house in October 1988, on speculation that it will find a buyer. In November 1988, A enters into a contract with B under which B agrees to purchase the house upon completion of construction. The construction of the home is not complete on December 31, 1988. A's contract with B is a contract for the building or construction of property within the meaning of section 460(f)(1), even if characterized by the parties as a contract for the sale of the house, since A must build or construct property to comply with the contract. Assuming, however, that the contract is a "home construction contract" within the meaning of section 460(e)(1)(A) and (e)(6)(A), A is not required to use the percentage of completion method or the percentage of completion-capitalized cost method of accounting for regular tax purposes because A entered into the contract after June 20, 1988. See Q&A-42. A must account for the contract using the rules of section 263A and the regulations thereunder. In addition, because A's average annual gross receipts exceed $10 million, A is required to use the percentage of completion method for purposes of determining A's alternative minimum tax liability. See Q&A-46.

EXAMPLE (3). The facts are the same as in Example (2) except that A begins construction of the house in October 1987 and enters into a contract with B in November 1987. A is required to use the percentage of completion or percentage of completion-capitalized cost method of accounting for the contract under section 460 as amended by the 1987 Act.

EXAMPLE (4). The facts are the same as Example (3) except that A completes construction of the house and subsequently enters into a contract with B for the purchase of the house. Because A is not required to build or construct property to complete the contract, the contract is not a long-term contract subject to section 460.

EXAMPLE (5). C, a calendar year home builder with average annual gross receipts of more than $10 million, enters into a contract with D on July 1, 1988 to build a house for D. D has title to the lot on which the house is built, provides C with all materials, and has title to the house while he house is under construction. The contract is completed in February 1989. The contract is a contract for the construction of property, notwithstanding the fact that C does not have title to the subject matter of the contract. The contract is, therefore, a long-term contract within the meaning of section 460(f). Assume that the contract is a "home construction contract" within the meaning of section 460(e)(1)(A). Because the contract was entered into after June 20, 1988, C is not required to use the percentage of completion method or the percentage of completion- capitalized cost method of accounting. C must account for the contract using the rules of section 263A and the regulations thereunder. Thus, C must capitalize all of its costs incurred in constructing the home, including labor costs, interest, and all indirect costs allocable to the construction activities under section 263A and the regulations thereunder. See section 460(e)(1). In addition, because C's average annual gross receipts exceed $10 million, C is required to use the percentage of completion method for purposes of determining C's alternative minimum tax liability.

Q-5: What additional conditions apply in determining whether a contract for the manufacture of property is a long-term contract within the meaning of section 460(f)?

A-5: Under section 460(f)(2), a contract for the manufacture of property is not treated as a long-term contract unless the contract involves the manufacture of either (A) a unique item of a type that is not normally included in the finished goods inventory of the taxpayer, or (B) an item that normally requires more than 12 calendar months to complete (without regard to the period of the contract).

Since the item must meet only one of these two criteria, a manufacturing contract that is not completed in the taxable year in which it is entered into is a long-term contract within the meaning of section 460(f) if it is for the manufacture of an item that normally requires more than 12 calendar months to complete, even if the item is not unique. In determining the time normally required for the manufacture of an item, all activities of the taxpayer and of any related party relating to the manufacture must be taken into account. See H.R. Rep. No. 795, 100th Cong., 2d Sess. 470 (1988). Thus, the time required to manufacture an item is not limited to the time required to assemble the item and includes the time required for activities such as production of components and subassemblies by the taxpayer or by any related party. For purposes of this paragraph, a related party is a person whose relationship to the taxpayer is described in section 707(b) or 267(b), determined without regard to section 267(f)(1)(A) and determined by substituting "80 percent" for "50 percent" with regard to the ownership of the stock of a C corporation in subsections (b)(2), (b)(8), (b)(10)(A) and (b)(12) of section 267.

The rule of this Q&A-5 that the activities of related parties are to be taken into account in determining the normal production period of an item shall, in general, apply only to contracts entered into on or after June 21, 1988. However, this rule shall apply to any contract entered into after February 28, 1986 if (i) the taxpayer has arranged for a party whose relationship with the taxpayer is described in section 267(b) or 707(b) (and regardless of whether the degree of ownership requirements of the applicable section are satisfied) to perform a portion of the activities required to fulfill the contract, and (ii) a principal purpose of that arrangement is to avoid characterization of the contract as a long-term contract.

EXAMPLE. X, a construction equipment manufacturer that is a calendar year taxpayer, produces a type of crane. X purchases a number of the components of the crane from suppliers that are related parties. The manufacture of these components and their shipment to X normally takes 5 months to complete. Completion of a crane using these components normally requires an additional 8 months from the time X receives them. Therefore, the crane is an item of a type that normally requires more than 12 months to complete. X normally does not produce the cranes under contracts with particular customers, but instead produces the goods for finished goods inventory, and enters into contracts for sale of the cranes after they are completed. X begins work on several cranes on July 1, 1988. Notwithstanding X's normal practice of completing cranes before contracting for their sale, on December 1, 1988, X enters into a contract with buyers for the cranes. On February 1, 1989, X completes the cranes, one month ahead of schedule. The contract is a long-term contract within the meaning of section 460(f), even though the cranes are an item of a type that X normally includes in finished goods inventory, and even though the duration of the contract was only two months, because the crane is an item of a type that normally requires more than 12 calendar months to complete.

Q-6: Do the additional conditions set forth in Q&A-5 apply in determining whether a contract for the building, installation, or construction of property is a long-term contract?

A-6: No. A contract for the building, installation, or construction of property that is not completed in the taxable year in which it is entered into is a long-term contract even if the property is not unique and does not normally require more than 12 months to complete. Thus, for example, a contract to build a house or other building is a long-term contract if it is not completed in the taxable year in which it is entered into, because the requirements applicable to manufacturing (that the property must be unique or that each item normally require more than 12 months to complete) do not apply to building, construction, or installation contracts.

Q-7: For taxpayers that used a long-term contract method for contracts entered into prior to the effective date of section 460, what restrictions apply with respect to the criteria used by the taxpayer for determining whether similar contracts entered into on or after the effective date of section 460 are long-term contracts?

A-7: Any taxpayer that, immediately prior to the effective date of section 460, accounted for contracts based on the position that such contracts were long-term contracts under section 1.451-3(b) of the Income Tax Regulations, is required to account for such contracts (and any successor contracts) under section 460 unless the taxpayer obtains the consent of the Commissioner to change its method of accounting. This is true even if the taxpayer's position under prior law was based on an erroneous application of the definition of "long- term" contract in section 460(f) and this notice. For these purposes, the term "successor contracts" means all contracts which, under the criteria and methods used by the taxpayer prior to the effective date of section 460 in determining whether a contract was a long-term contract under section 1.451-3(b) of the regulations, would be or have been classified by such taxpayer as long-term contracts under section 1.451-3(b), regardless of whether those criteria and methods are correct. Thus, for example, it is anticipated that the criteria and methods used by a taxpayer in determining that items were "unique" prior to February 28, 1986, and thus were produced under long-term contracts, will continue to be used by the taxpayer unless the taxpayer obtains the consent of the Commissioner to change its method of accounting. See H.R. Rep. No. 495, 100th Cong., 2d Sess. 923 (1987).

Q-8: How does section 460 apply to activities performed by a taxpayer ("Y") for a related party ("X") that, considered by themselves, would not constitute a long-term contract between X and Y, but that benefit the performance of a long-term contract entered into by X with any customer of X?

A-8: If X has entered into a long-term contract after June 20, 1988, with a customer, and Y, a taxpayer that is related to X, performs any activities for or on behalf of X that benefit or are performed by reason of X's contract, then Y shall account under section 460 for its income and costs attributable to such activities. Such activities include, for example, the production of items, such as components or subassemblies, that are reasonably expected to be used in the production of the subject matter of X's contract. Y is required to account for such activities under section 460 regardless of whether Y's activities, considered by themselves, (i) constitute manufacture, building, construction, or installation of property, (ii) involve the manufacture of items that either are "unique" or require more than 12 months to complete, (iii) span the end of Y's taxable year, or (iv) are performed pursuant to a contract with X. For purposes of this paragraph, a related party is a person whose relationship to the taxpayer is described in section 707(b) or 267(b), determined without regard to section 267(f)(1)(A) and determined by substituting "80 percent" for "50 percent" with regard to the ownership of the stock of a C corporation in subsections (b)(2), (b)(8), (b)(10)(A) and (b)(12) of section 267.

In applying section 460, Y should treat as the total expected contract price the amount to be paid by X, if such amount represents an arm's length charge. If this amount does not represent an arm's length charge, then Y must use an arm's length charge as the total expected contract price. This arm's length charge must reflect both Y's contribution to the long-term contract being performed by X, and the contract price to be received by X. In addition, if Y treats as total expected contract price an arm's length charge that differs from the actual amount that X is obligated to pay, then X must treat that arm's length charge as the cost that X incurs with respect to Y's activities.

For purposes of determining its own percentage of completion, X shall take into account the amount that it accrues as payable to Y (or is treated as accruing as payable to Y under the preceding paragraph) at the time that X accrues such amount, rather than at the time that Y incurs costs to perform activities benefiting X's long- term contract.

The rule of this Q&A-8 requiring that certain activities of related parties such as Y be accounted for under section 460 even though such activities do not, by themselves, constitute a long-term contract shall in general apply only to contracts entered into by X on or after June 21, 1988. However, this rule shall apply to any contract entered into after February 28, 1986, if X has arranged for a party whose relationship with X is described in section 707(b) or 267(b) (and regardless of whether the degree of ownership requirements of the applicable section are satisfied) to perform a portion of the activities required to fulfill the contract, and a principal purpose of that arrangement is to avoid the application of section 460 to the income and expenses attributable to such activities.

EXAMPLE. On July 1, 1988, X, an accrual method taxpayer, enters into a long-term contract within the meaning of section 460(f) to produce 5 aircraft for C. Y1, an 80-percent-owned subsidiary of X and also an accrual method taxpayer, incurs costs in 1988 and 1989 to perform research, development, engineering and design work necessary to produce the aircraft. Assume that, if X had performed these activities itself, the costs would have been properly allocable to the contract. This work is completed in 1989. Y2, also an 80-percent-owned subsidiary of X, and also an accrual method taxpayer, manufactures engines in 1989 and 1990 for the aircraft. Y2's work is completed in 1990. Assume that X pays Y1 and Y2 amounts that are arm's length charges as determined under the principles of section 482, with such charges reflecting both the contributions of Y1 and Y2 to the contract being performed by X and the price to be received by X.

Both Y1 and Y2 must account for their activities under section 460 regardless of whether (i) Y1's activities considered by themselves would constitute the manufacture of property, (ii) the aircraft engines are "unique" or require more than 12 months to complete, and (iii) Y1 and Y2 have entered into contracts with X. Y1 must include the amount to be payable by X in income in 1988 and 1989, and Y2 must include the amount to be payable by X in 1989 and 1990, under either the percentage of completion or percentage of completion-capitalized cost method, under the rules applicable to long-term contracts entered into on July 1, 1988. Y1 and Y2 must apply the look-back method in 1989 and 1990, respectively. Y1 and Y2 are subject to the cost allocation rules of section 460(b). X is not required to take the costs incurred by Y1 and Y2 into account in determining its own percentage of completion for 1988 through 1990. Instead, X takes into account the amounts that it accrues as payable to Y1 and Y2 in determining its percentage of completion at the time that X incurs such amounts. See Q&A-32 and Q&A-33.

IV. EFFECTIVE DATE OF SECTION 460

Q-9: When is section 460 effective?

A-9: Section 460 (including the interest allocation requirements of section 460(c)(3)) and the rules set forth in this notice are, except as expressly provided to the contrary in this notice, effective for long-term contracts entered into after February 28, 1986, beginning with taxable years ending after February 28, 1986. For rules governing the accounting for costs allocable to contracts entered into after February 28, 1986, but incurred in taxable years ending before March 1, 1986, see Q&A-29 and Q&A-36. No inference is intended concerning the extent to which the rules applicable after the effective date of section 460 would apply to issues arising under the law in effect before the enactment of section 460.

Q-10: Does section 460 apply to a contract that is entered into by the taxpayer before March 1, 1986, but is assigned by the taxpayer on or after that date to another person?

A-10: The assignee must account for such a contract under section 460 unless (i) none of the terms of the contract are changed in connection with the assignment, and (ii) the assignee agrees to perform all of the assignor's remaining obligations under the contract and becomes entitled to all remaining payments under the contract. If the conditions of the previous sentence are met, such a contract is not subject to section 460 even if the assignor does not remain liable to the customer after the assignment and even if the assignee becomes liable to the customer. This rule applies regardless of whether the assignor and assignee are related persons, and regardless of whether the assignment occurs in connection with a taxable sale or a nontaxable transaction. The assignee must account for contract income and costs using its "normal" method of accounting for long-term contracts (as defined in Q&A-18) as of the date of the transfer (which may or may not be the same as the normal method of accounting of the assignor), except as provided in section 381 of the Code, or any other applicable provision of the Code or regulations. If the assignee has not adopted a method of accounting for long-term contracts as of the time of the transfer (as may be the case if, for example, the assignee is a new taxpayer, or has never performed a long-term contract), the assignee generally may use any method of accounting for a long-term contract permitted under section 1.451-3 of the regulations (e.g., the completed contract method or the accrual method). If, however, such an assignee has a relationship to the assignor described in section 267(b) or 707(b) immediately after the assignment, then the assignee must use the assignor's normal method. For this purpose, whether the assignee and assignor have a relationship described in section 267(b) shall be determined without regard to section 267(f)(1)(A) and by substituting "80 percent" for "50 percent" with regard to the ownership of the stock of a C corporation in subsections (b)(2), (b)(8), (b)(10)(A) and (b)(12) of section 267.

EXAMPLE (1). On February 1, 1986 X Corporation enters into a construction contract with Y. On November 1, 1987, X sells the assets of its division that was performing the contract to Z corporation. As part of the asset sale, Z agrees to perform all of X's obligations under the contract, and X assigns to Z all of its rights under the contract, including the right to all remaining payments under the contract. Y agrees to release X from its obligations under the contract, and Z becomes legally obligated to Y. There is no change in the terms of the contract. Thus, Z does not agree to perform any additional work that X was not obligated to perform, and no adjustment is made in the contract price that Y is obligated to pay. Because X's contract with Y was entered into prior to March 1, 1986, Z is not subject to section 460 in accounting for contract income and costs.

EXAMPLE (2). The facts are the same as in Example (1), except that the terms of the contract (e.g., the total price to be paid by Y) are changed in connection with the transaction. Z is subject to section 460 in accounting for contract income and costs.

Q-11: Does section 460 apply to revenues and expenses attributable to a change order or other similar agreement entered into by the taxpayer and the customer after February 28, 1986 but relating to a contract entered into on or before that date?

A-11: A change order or other similar agreement entered into by the taxpayer and the customer after February 28, 1986, is subject to section 460 if it is treated as a separate contract under the rules for severing contracts described in Q&A-37 and Q&A-38.

EXAMPLE. Y enters into a contract on February 1, 1986, with an agency of the Federal Government to build two submarines. On November 1, 1987, the customer and taxpayer agree to a change order providing for a third submarine of the same class to be built by Y. Because the change order is treated as a separate contract under the rules for severing contracts described in Q&A-37, Y must account for costs and income allocable to the third submarine in accordance with section 460.

Q-12: Is a contract considered to have been entered into even if the contract is subject to conditions that have not yet been met?

A-12: Yes. A contract is considered to have been entered into even if it is subject to conditions not within the control of the taxpayer that have not yet been met, so long as the contract is a binding contract under applicable law.

EXAMPLE. On December 1, 1985, X, a builder, enters into a contract with Y to build a home. Although the contract is contingent on Y's obtaining financing, it is a binding contract under applicable law. Y obtains financing on March 1, 1986. The contract is not subject to section 460, because it was entered into before March 1, 1986, even though it was subject to a condition that was met on or after that date.

Q-13: If a taxpayer has failed to comply with section 460 with respect to one or more contracts entered into after February 28, 1986 for one or more tax years ending after that date, how should the taxpayer correct its method of accounting?

A-13: A taxpayer that has failed to comply with section 460 must change its method of accounting for long-term contracts to conform to section 460 under the following procedures. These procedures are to be used rather than the procedures provided in Rev. Proc. 84-74, 1984-2 C.B. 736. Under this notice, the taxpayer is directed to and is granted consent to conform its method of accounting to a method required under section 460, provided that (1) section 6501 (the applicable statute of limitations) would permit assessment of tax for all years for which the taxpayer has failed to report income and expenses in accordance with section 460, and (2) the taxpayer files amended returns for all such years.

If section 6501 would not permit assessment of tax for all tax years for which the taxpayer has failed to report income and expenses in accordance with section 460, then the taxpayer shall, pursuant to section 446, request the consent of the Commissioner to change its method of accounting for all contracts entered into after February 28, 1986 to a method required by section 460. Such change shall be effective for the earliest tax year for which section 6501 would permit assessment of tax. As a condition of such change, the taxpayer shall file amended returns for the year of change and all subsequent years. Any adjustment required under section 481 as a result of such change shall be taken into account under such terms as may be prescribed by the Commissioner.

V. DETERMINATION OF WHETHER PERCENTAGE OF COMPLETION OR PERCENTAGE OF COMPLETION-CAPITALIZED COST METHOD IS TO BE USED

Q-14: What rules apply in determining whether the percentage of completion method of accounting rather than the percentage of completion-capitalized cost method of accounting is to be used by a taxpayer for a particular long-term contract entered into after February 28, 1986?

A-14: If, immediately prior to the effective date of section 460, the taxpayer used the percentage of completion method of accounting for all long-term contracts within a particular trade or business, then the taxpayer is required to use the percentage of completion method of accounting (as modified by section 460 and explained in Q&A-19 through Q&A-36) for all items of income from and all costs allocable to all long-term contracts within that trade or business entered into after February 28, 1986, unless the taxpayer has obtained the consent of the Commissioner to use a different method of accounting.

If, immediately prior to the effective date of section 460, a taxpayer used a method of accounting other than the percentage of completion method for all long-term contracts within a particular trade or business, then the taxpayer shall use the percentage of completion-capitalized cost method for all long-term contracts within that trade or business (other than contracts exempt under section 460(e)(1)) entered into after February 28, 1986, unless one of the following conditions is met: (1) the taxpayer has changed its method of accounting to the percentage of completion method (e.g., pursuant to Notice 87-61, 1987-2 C.B. 370, or Notice 88-66, 1988-25 I.R.B. 41, or Q&A-47) for all items under all long-term contracts within that trade or business entered into after February 28, 1986; (2) the taxpayer has changed its method of accounting (e.g., pursuant to Notice 88-66 or Q&A-47) to the percentage of completion method for all items under all long-term contracts within that trade or business entered into after October 13, 1987; or (3) the taxpayer has changed its method of accounting (e.g., pursuant to Q&A-47) to the percentage of completion method for all long-term contracts entered into after June 20, 1988; or (4) the taxpayer has obtained the consent of the Commissioner to use a different method of accounting.

Immediately prior to the effective date of section 460, under section 1.451-3(a)(1) of the regulations, some taxpayers were permitted to use the percentage of completion method for certain long-term contracts within a particular trade or business, but to use another method of accounting for other long-term contracts within that trade or business. For example, the taxpayer might have used the percentage of completion method for long-term contracts of substantial duration and an accrual method for long-term contracts of less than substantial duration. Such a taxpayer must use the percentage of completion method, as modified by section 460, to account for all items under all long-term contracts entered into after February 28, 1986 that are of a duration such that they would have been accounted for under the percentage of completion method, based on the standards applied by the taxpayer, prior to the effective date of section 460. Such a taxpayer must use the percentage of completion-capitalized cost method to account for all items under all long-term contracts entered into after February 28, 1986 that are of a duration such that they would have been accounted for under a method other than the percentage of completion method, based on the standards applied by the taxpayer prior to the effective date of section 460. The requirements of the two preceding sentences shall apply unless the taxpayer has changed to the percentage of completion method pursuant to Notice 87-61, Notice 88-66, or Q&A-47, or has obtained the consent of the Commissioner.

VI. PERCENTAGE OF COMPLETION-CAPITALIZED COST METHOD

Q-15: Under the percentage of completion-capitalized cost method, when are items of revenue from and items of cost allocable to a long-term contract taken into account?

A-15: Under the percentage of completion-capitalized cost method of accounting, a certain percentage of each item of revenue and each item of cost is taken into account at the time that such item would be taken into account using the percentage of completion method for the contract, and the remaining percentage is taken into account at the time that such item would be taken into account using the taxpayer's "normal" method of accounting for the contract. The percentage of each item to be taken into account under each of these two methods of accounting depends on the date that the contract was entered into. For contracts entered into after February 28, 1986, but before October 14, 1987, 40 percent of each item of revenue or cost is taken into account under the percentage of completion method and the remaining 60 percent is taken into account under the taxpayer's normal method of accounting (the "40/60 method"). In general, for contracts entered into after October 13, 1987, but before June 21, 1988, 70 percent of each item of revenue or cost is taken into account under the percentage of completion method and the remaining 30 percent is taken into account under the taxpayer's normal method of accounting (the "70/30 method"). In general, for contracts entered into on or after June 21, 1988, 90 percent of each item of revenue or cost is taken into account under the percentage of completion method and the remaining 10 percent is taken into account under the taxpayer's normal method of accounting (the "90/10 method").

The following exceptions apply to these general rules, however. First, certain ship contracts described in section 10203 of the Revenue Act of 1987 entered into after October 13, 1987, are not required to be accounted for under either the 70/30 method or the 90/10 method. Such ship contracts are required to be accounted for using either the percentage of completion method or the 40/60 method. Second, "residential construction contracts" entered into on or after June 21, 1988, are not required to be accounted for under the 90/10 method. Unless they meet the requirements of section 460(e)(1)(B), such residential construction contracts are required to be accounted for under either the percentage of completion method or the 70/30 method. Third, a contract is not required to be accounted for under the 90/10 method if the contract results from the acceptance of a bid made before June 21, 1988, and the bid could not have been revoked or altered at any time on or after June 21, 1988. Fourth, except for the interest capitalization requirements of section 460(c)(3), section 460 does not apply to any "home construction contract" entered into after June 20, 1988. Unless such a contract meets the requirements of section 460(e)(1)(B), the uniform capitalization rules of section 263A and the regulations thereunder will apply to it. See Q&A-41 through Q&A-44 for definitions and rules relating to "residential" and "home" construction contracts. See Q&A-46 for rules relating to the application of the alternative minimum tax to long-term contracts described in section 460(e).

Q-16: In applying the percentage of completion-capitalized cost method of accounting, is a taxpayer permitted to reduce the amount of contract revenue required to be taken into account in a particular year under the taxpayer's normal method of accounting by the amount of contract revenue taken into account under the percentage of completion method in that year and previous years?

A-16: No. The amount of contract revenue taken into account in a particular year under the taxpayer's normal method of accounting is not affected by the amount of contract revenue required to be taken into account in any year under the percentage of completion method. Similarly the amount of contract revenue taken into account under the percentage of completion method is not affected by the amount of contract revenue taken into account in any year under the taxpayer's normal method.

EXAMPLE. After October 13, 1987, but before June 21, 1988, X enters into a long-term contract that is accounted for under the percentage of completion-capitalized cost method using the 70/30 method. X's normal method of accounting is an accrual method. Assume that if X were using the percentage of completion method for the contract, X would be required to take into account $500,000 of contract revenue in 1988. Assume that if X were using the accrual method, X would be required to take into account $200,000 of contract revenue in 1988. Under the percentage of completion-capitalized cost method, X is required to take into account the following amounts of contract revenue in 1988: 70 percent of $500,000, or $350,000, plus 30 percent of $200,000, or $60,000, for a total of $410,000.

Q-17: How should a taxpayer that (i) uses the percentage of completion-capitalized cost method of accounting, with an accrual method as its normal method, and (ii) uses the dollar value last-in, first-out (LIFO) method of valuing its inventories apply the LIFO method to value inventories in a pool that includes items being produced under a long-term contract?

A-17: The taxpayer should include in inventory only that percentage of each unit being produced under a long-term contract that is equal to the percentage (60%, 30%, or 10%) of income and costs for such contract that is accounted for under the taxpayer's normal method. To the extent that raw materials included in the pool have been dedicated to a long-term contract, only that portion of such raw materials that is equal to such fraction (i.e., 60%, 30%, or 10%) should be treated as remaining in inventory. Thus, inventory will include fractional units of raw materials, goods in process, and finished goods (as well as whole units if the same pool includes items that are not being produced under a long-term contract).

The following example illustrates the use of the dollar-value LIFO inventory method in conjunction with the percentage of completion-capitalized cost method for long-term contracts:

EXAMPLE. X is engaged in the manufacture of a single type of metal component for customers in the aerospace industry. The metal component normally takes more than 12 months to manufacture. Since it began business, X sold metal components to customers only from its inventory of finished goods. However, for financial reasons, X modified this practice in 1987 and decided to obtain contracts from a customer in some cases prior to completing the manufacture of a component. X continued to manufacture and sell approximately one-half of its components without first obtaining a contract.

X uses a calendar-year tax year and an overall accrual method to report taxable income. X accounts for the cost of its inventory using the dollar-value LIFO inventory method and the natural business unit pooling method. X uses the double- extension method to compute its LIFO index. X's metal components consist of one type of raw material, and each finished component requires 6 units of raw material and 10 units of labor. X's unit costs are determined on a fully capitalized basis and, therefore, reflect all indirect costs required to be capitalized. Moreover, X does not incur research and experimental expenses and, consequently, its unit costs for items produced under a contract and for items sold from inventory do not differ.

Assume that, since the year X began business, X's ending inventory has always consisted of 20 units of raw material, two half-completed components in work-in-process, and two completed components. Thus, at the beginning of 1987, the LIFO value of X's inventory equals the base-year cost of these items and, accordingly, represents a single LIFO layer accumulated in the base year as shown below in Table 1.

(Note: In the following tables, "M" represents materials, and "L" represents labor.)

                                TABLE 1

Because X's components normally require more than 12 months to complete, X's contracts to manufacture the components meet the definition of a long-term contract under section 460(f) of the Code. Assuming that X uses an accrual method as its normal method of accounting for long-term contracts, X must account for the cost of components manufactured under a contract using the percentage of completion-capitalized cost method and, therefore, must apply the dollar-value LIFO inventory method to less than 100 percent (i.e., 60%, 30%, or 10% depending on the date each particular long-term contract is entered into) of the cost of each of these components. Accordingly, assuming again that the volume and mix of raw materials, unfinished components and finished components remains unchanged at the end of 1987, the LIFO value of X's ending inventory will change because X is required by the operation of section 460 to include only a percentage of the cost of components manufactured under a long- term contract in its dollar-value LIFO pool as shown below in Table 2. Note, however, that X does not remove a percentage of the cost of any of the 20 units of raw material from the LIFO pool until those units are dedicated to one of its long-term contracts. See Q&A-35.

                                TABLE 2

                                TABLE 3

Q-18: What is meant by a taxpayer's "normal" method of accounting?

A-18: In general, a taxpayer's normal method of accounting is the method of accounting that the taxpayer used immediately prior to the effective date of section 460 to account for its long-term contracts within a particular trade or business. This method of accounting might have been, for example, the completed contract method provided by section 1.451-3(d) of the regulations, the cash method, an accrual method such as the accrual shipment, or accrual delivery method.

If, however, the taxpayer has been required by law or has obtained the consent of the Commissioner o change from its normal method to a new method of accounting, then the new method is treated as the taxpayer's normal method of accounting. For example, section 263A may require a change in the taxpayer's normal method of accounting. Similarly, section 448 may require a taxpayer that used the cash method of accounting for long-term contracts immediately prior to the effective date of section 460, to change from the cash method to another method of accounting pursuant to section 448. In this case, that other method of accounting becomes the taxpayer's normal method of accounting for purposes of applying the percentage of completion-capitalized cost method. Although section 448 generally requires that certain taxpayers change from the cash to the accrual method, section 1.448-1T(h)(3) of the regulations may permit a change to the completed contract method in certain cases.

VII. PERCENTAGE OF COMPLETION METHOD

Q-19: Under the percentage of completion method, what portion of the total price under a particular contract is required to be included in gross income in a particular taxable year?

A-19: Under the percentage of completion method, the taxpayer must include in gross income in each taxable year ending after the date that the contract is entered into an amount equal to the excess of (1) the product of (a) the total amount of revenue that the taxpayer estimates it will receive with respect to the contract, multiplied by (b) the cumulative percentage of the contract that has been completed as of the end of the taxable year, over (2) the total cumulative amount of contract revenue required to be included in gross income in all preceding taxable years. This amount may be expressed by the following formula:

           (TCR x PC) - I

If the total cumulative amount of contract revenue required to be included in gross income in all preceding taxable years exceeds the product of total expected contract revenues for the taxable year multiplied by the cumulative percentage of the contract completed as of the end of the taxable year, then the taxpayer shall be permitted to deduct the excess as a loss for the taxable year. This may occur, for example, as a result of increases in total estimated contract costs occurring after the end of the tax year in which the contract in entered into.

Q-20: How does a taxpayer determine the percentage of the contract that has been completed as of the end of the taxable year?

A-20: Unless the taxpayer uses the simplified method described in Q&A-22 and Q&A-23, the percentage of the contract considered completed as of the end of the taxable year is equal to the ratio of (a) the total cumulative amount of costs allocable to the contract and incurred in the taxable year and in all preceding taxable years, to (b) the total amount of costs allocable to the contract that the taxpayer expects to incur. The total estimated contract costs may be different for the different years of the contract. See Q&A-24.

Q-21: Should a taxpayer that properly uses the cash method as its over-all method of accounting treat a cost as incurred in the taxable year in which it is paid for purposes of determining the total amount of costs allocable to the contract incurred in a particular taxable year?

A-21: No. Section 460 provides that, in determining percentage of completion, costs are taken into account in the taxable year that they are incurred, regardless of the taxpayer's over-all method of accounting. Similarly, under the percentage of completion method, costs allocable to the contract are deductible in the year incurred, regardless of the taxpayer's overall method of accounting. For this purpose, an item is treated as incurred when it would properly be taken into account under an accrual method of accounting, including the rules of section 461(h). See Q&A-33 through Q&A-35 for further discussion.

Q-22: How is percentage of contract completion determined under the simplified method?

A-22: Under the simplified method, only certain costs are used in determining both (i) costs allocated to the contract and incurred before the close of the taxable year, and (ii) total estimated contract costs. These costs are: (a) direct material costs and direct labor costs, and (b) depreciation, amortization and cost recovery allowances on equipment and facilities (to the extent allowable as deductions under Chapter 1 of the Code) directly used to construct or produce the subject matter of the long-term contract. Direct material costs include the costs of materials such as raw materials, land, equipment and components that become an integral part of the subject matter of a long-term contract and the costs of those materials that are consumed in the ordinary course of building, constructing, installing, or manufacturing the subject matter of a long-term contract.

Q-23: Which taxpayers may use the simplified method?

A-23: The simplified method may be used by taxpayers using the percentage of completion method for all items under all long-term contracts in a particular trade or business. A taxpayer that, pursuant to Q&A-14, uses the percentage of completion method for long-term contracts of substantial duration and the percentage of completion-capitalized cost method for long-term contracts of less than substantial duration, may not use the simplified method for its long-term contracts of substantial duration.

A taxpayer using the percentage of completion-capitalized cost method that properly uses the cash method as its normal method of accounting may also use the simplified method. However, any such taxpayer must automatically change from the simplified method for the first taxable year that the taxpayer is required to change from the cash method under any provision of law, including section 448, unless the taxpayer properly changes its method of accounting to the percentage of completion method for all items under all long-term contracts in its trade or business.

Use of the simplified method is a method of accounting and may not be revoked without the consent of the Commissioner. The Commissioner may, by revenue procedure, or other administrative pronouncement, permit taxpayers to adopt the simplified method without obtaining consent. See, e.g., Notice 87-61.

Q-24: In determining percentage of completion for a particular taxable year, when are total contract costs and total contract revenues to be estimated?

A-24: Total contract revenue and total contract costs are to be estimated based on the facts and reasonable estimates as of the last day of the taxable year. Events that occur after the end of the taxable year that were not reasonably subject to estimate as of the last day of the taxable year are not taken into account.

EXAMPLE. X, a calendar year taxpayer, enters into a long- term contract on January 1, 1987. Based on the facts as of December 31, 1987, X reasonably estimates that total contact revenue will be $10m and total contract costs will be $5m. X's employees go on strike in February, 1988, causing X to increase its estimate of total contract costs to $6m. After the strike is settled, X receives an order from the customer for additional work under the contract. Assume that this order would not be treated as a separate contract under the rules for severing contracts set forth in Q&A-37. Based on this order, X increases its estimate of total contract costs to $8m, and increases its estimate of total contract revenues to $15m. In applying the percentage of completion method to determine the amount of contract revenue required to be included in gross income in 1987, reasonable estimates of total contract revenue and costs based on the facts as of December 31, 1987, are to be used. Revisions to these estimates based on the strike and the change order occurring in 1988 are not taken into account, even though these revisions were made before X filed its tax return for 1987.

Q-25: Are contingency allowances for extraordinary costs to be included in total estimated contract costs for purposes of computing percentage completion?

A-25: Total estimated contract costs do not include any contingency allowance for costs that, as of the end of the year for which the estimate is made, are unforeseeable or extraordinary and are not reasonably expected to be incurred in the performance of the contract. Thus, for example, total estimated costs do not include costs attributable to abnormal factors not reasonably foreseeable as of the end of the tax year for which the estimate is made, such as prolonged third-party litigation, abnormal weather conditions (considering the season and the job site), prolonged strikes, and prolonged delays in securing required permits and licenses, and other factors that, as of the end of the year for which the estimate is made, could not be reasonably anticipated considering the nature of the contract and prior experience of the taxpayer.

Q-26: Are estimated costs of performing other contracts (such as "follow-on contracts") that the taxpayer expects to enter into with the same customer as a result of having entered into a particular contract included in total estimated contract costs for the initial contract?

A-26: No. The estimated costs of performing such a contract are not included in total estimated contract costs for the initial contract unless the contract would not be treated as a separate contract under the severing and aggregating rules described in Q&A- 37.

Q-27: For purposes of applying the percentage of completion method, are "retainages" and "holdbacks" included in total expected contract revenues?

A-27: Yes. All amounts that the taxpayer is or will be entitled to receive from the customer under the contract, or any other rule of law (including, for example, the contract law rule of quantum meruit, or other quasi-contractual remedies) must be included in total expected contract revenues, including amounts, such as retainages, that the customer has contracted to pay only upon satisfactory completion of the contract. (See also section 460(b)(2)(B), which requires that such amounts, including amounts received after contract completion, be included in total contract price for purposes of applying the look-back rule.)

Q-28: For purposes of applying the percentage of completion method, does a taxpayer include in total expected contract revenues award fees and similar incentive payments that the taxpayer is entitled to receive under the contract if certain requirements, in addition to satisfactory completion and acceptance, are met?

A-28: Payments such as award fees, or incentive payments, are to be included in total expected contract revenues at the time and to the extent that the taxpayer can reasonably predict that the corresponding performance objectives will be met.

Q-29: If a taxpayer incurs costs allocable to a contract in a taxable year ending prior to the date that the contract is entered into, does the percentage of completion method require inclusion of any portion of the expected contract revenue in gross income in such prior taxable year?

A-29: No. Under the percentage of completion method the taxpayer is not required to include any amount in gross income in any taxable year ending prior to the date that a contract is entered into, even if costs allocable to the contract are incurred in such a taxable year. With respect to costs incurred in a taxable year prior to the year a contract is entered into, if (i) it is reasonably foreseeable at the time that the costs are incurred that they relate to a long- term contract that will be entered into during a future year, and (ii) the costs are of a nature such that they would otherwise be allocable to the contract under section 460(c), then such costs are to be capitalized in the year in which they are incurred. If, in contrast, it is not reasonably foreseeable at the time that costs are incurred that they relate to a long-term contract that will be entered into during a future year, then such costs are to be accounted for and capitalized under the provisions of section 263A (if such costs are incurred in a taxable year to which section 263A applies). In either case, in the subsequent year in which the contract is entered into, all such costs are to be allocated to the contract and taken into account in determining the completion percentage and, thus, in determining the amount of contract revenue required to be taken into account in the subsequent taxable year in which the contract is entered into. See Q&A-36, which provides for the time for deducting such costs.

Q-30: For the purpose of computing percentage of completion, are nondeductible costs taken into account in determining (i) expected total costs allocable to a contract, or (ii) costs allocable to a contract and incurred through the end of the taxable year?

A-30: No. For these purposes, nondeductible costs are not taken into account, even if otherwise allocable to a contract under section 460(c) and Q&A-39 and Q&A-40. Thus, for example, the following costs would not be taken into account in computing percentage of completion: (i) any payments disallowed under section 162(c); and, (ii) meals and entertainment costs disallowed under section 274.

Q-31: Under the percentage of completion method, what is the treatment of amounts received or to be received by the taxpayer from the customer as reimbursements for costs incurred in performing a long-term contract?

A-31: These reimbursements are included in total contract price in determining the amount included in gross income in the taxable year under the percentage of completion method. Similarly, reimbursed costs allocable to a contract that have been incurred by the taxpayer are treated as contract costs in determining percentage of completion for the taxable year in which such costs are incurred. See Q&A-32 and Q&A-33.

Q-32: How are costs that are allocable to a contract taken into account under the percentage of completion method?

A-32: Under the percentage of completion method, costs that are allocable to a contract are allowable as deductions from gross income in computing taxable income in the year in which they are incurred. The preceding sentence shall not apply if such costs are disallowed permanently under any provision of the Code or regulations, including, for example, section 162(c) or section 274.

Q-33: Under the percentage of completion method, when is a cost that is allocable to a long-term contract treated as incurred, and therefore as deductible and taken into account in computing percentage of completion for the taxable year?

A-33: Regardless of the taxpayer's overall method of accounting, contract costs generally are treated as incurred in the taxable year in which the "all events" test of section 461 and section 1.461- 1(a)(2) of the regulations, as modified by section 461(h), is met. Thus, costs that are not treated as incurred as of the end of the taxable year for failure to satisfy the economic performance rules of section 461(h) are not deductible. Similarly, such costs are not treated as contract costs incurred through the end of the taxable year in determining percentage of completion (although those costs are taken into account in determining total expected contract costs). See Q&A-35 for rules relating to the time at which costs of direct materials and supplies are allocable to a contract.

Q-34: When are the costs of materials and supplies deductible under the percentage of completion method?

A-34: These costs are deductible under the percentage of completion method for the first taxable year in which the costs both are allocable to the contract and have been incurred. See Q&A-33 for rules as to when a cost that is allocable to a contract are treated as incurred. See Q&A-35 for rules as to when costs of materials and supplies are allocable to a contract.

Q-35: When are costs of direct materials and supplies treated as allocable to the contract under the percentage of completion method?

A-35: The costs of direct materials and supplies that are purchased specifically for a particular long-term contract are allocable to the contract in the taxable year in which such costs are incurred. The costs of other direct materials and supplies (such as those previously held by the taxpayer) are allocable to the contract in the taxable year in which such materials and supplies are dedicated to the contract. Examples of dedication include the following: (i) delivery of materials to a job site (if only one contract is being performed at that site); (ii) association of materials with a specific contract (for example, by purchase order, entry on books and records, or shipping instructions); and, (iii) if not previously assigned, the physical incorporation of the materials into the subject matter of the contract, or the consumption of the materials in the production of the subject matter of the contract. The cost that is allocated to a contract is to be determined using the taxpayer's method of accounting for such materials or supplies (e.g., specific identification, FIFO, or LIFO) based on the taxable year in which such items are dedicated to the contract.

Q-36: When are costs that are allocable to a long-term contract, but are incurred prior to the date that the contract is entered into, deductible and taken into account for purposes of determining degree of contract completion?

A-36: Such costs are treated as allocated to the contract and are deductible in the taxable year in which the contract is entered into. These costs might include, for example, bidding and proposal costs allocable to the contract, raw land purchased before a construction contract was entered into, and labor costs incurred in anticipation that a contract will be awarded. See Q&A-29 regarding accounting for income attributable to such costs.

EXAMPLE. In 1988 X Corporation, a calendar year taxpayer using the percentage of completion method, incurs costs to prepare a bid and proposal for a manufacturing contract with an agency of the United States government. In anticipation that the contract will be awarded, X also begins work in 1988 to produce the property that is expected to be the subject matter of the contract, incurring labor, materials, storage costs incurred to store the raw materials, and other costs allocable to this property under section 263A and the regulations thereunder. Then, on February 1, 1989, the contract is awarded and becomes legally binding on both the taxpayer and the agency. None of the bidding and proposal costs are deductible in 1988. Similarly, none of the other costs allocable to the property that is expected to be the subject matter of the contract are deductible in 1988. All of these costs are allocated to the contract on February 1, 1989. Therefore, all of these costs (bidding and proposal costs, as well as labor, materials, storage costs incurred to store the raw materials, and indirect costs allocable under section 263A to the property that is expected to be the subject matter of the contract) are deductible by X in 1989, and are taken into account by X in determining percentage of completion for 1989.

VIII. SEVERING AND AGGREGATION OF CONTRACTS

Q-37: What standards apply in determining whether an agreement should be treated as more than one contract ("severed"), or whether two or more agreements should be treated as a single contract ("aggregated") under section 460(f)(3)?

A-37: Except as provided in Q&A-38, the rules set forth in section 1.451-3(e) of the regulations apply in making this determination.

Q-38: May the taxpayer sever and aggregate contracts, or may such action be taken only by the Commissioner?

A-38: Under section 460(f)(3), a taxpayer is permitted and required to sever and aggregate contracts, notwithstanding the statement to the contrary in section 1.451-3(e)(1)(i)(C) of the regulations, which does not apply to contracts subject to section 460 and this Notice. Forthcoming regulations may require any taxpayer that severs or aggregates contracts under this Q&A-38 to attach a statement to its Federal income tax return for the first year in which it has entered into two or more agreements that are properly treated as a single contract, or a single agreement that is properly treated as more than one contract. If required, such a statement would describe the criteria used by the taxpayer in determining to sever or aggregate the agreements.

IX. ALLOCATION OF COSTS TO CONTRACTS

Q-39: What costs are required to be allocated to a long-term contract?

A-39: All costs (including, where applicable, research and experimental costs and interest costs) that directly benefit or are incurred by reason of the long-term contract activities of the taxpayer must be allocated to those contracts in the same manner that costs are allocated to extended period long-term contracts under section 1.451-3(d) of the regulations. For purposes of section 460(c), costs included in the preceding sentence and thus allocated to long-term contracts include all storage, handling, and processing costs incurred with respect to the long-term contract activities of the taxpayer. (See section 263A and the regulations thereunder for definitions of storage, handling, and processing costs.) Moreover, in the case of a cost-plus long-term contract or a Federal long-term contract, any cost not otherwise allocated to the contract under the general rule of the preceding sentence shall be allocated to the contract if the cost is identified by the taxpayer (or a related person) as being attributable to such contract, pursuant to the contract or any Federal, State, or local law or regulation. If, under a Federal or a cost-plus contract, the costs identified under the contract include a charge for the time value of money, that amount shall be treated as allocable to the contract without regard to whether the property produced is "qualified" property (as defined in Notice 88-99) with respect to which interest is required to be capitalized under section 460(c)(3).

The following costs are not subject to the rules of section 460 and are not allocable to long-term contracts: independent research and development expenses (as defined in section 460(c)(5)); expenses for unsuccessful bids and proposals; and marketing, selling and advertising expenses. Therefore, such costs are not taken into account in determining degree of contract completion under the percentage of completion method, and no portion of such costs is required to be capitalized under the percentage of completion- capitalized cost method by a taxpayer using the completed contract method as its normal method of accounting.

The use, direct or indirect, of the practical capacity concept to account for the costs required to be allocated to long-term contracts is not permitted. The practical capacity concept is defined as any concept, method, procedure, or formula (such as the practical capacity concept described in section 1.471-11(d)(4) of the regulations) whereunder fixed costs are not capitalized or allocated to a contract because of the relationship between the actual production at the taxpayer's production facility and the "practical capacity" of such facility. For this purpose, the practical capacity of a facility shall include either the practical capacity or theoretical capacity of the facility (as defined in section 1.471- 11(d)(4) of the regulations), or any other similar determination of productive or operating capacity.

Q-40: What methods are available in accounting for the indirect costs required to be allocated to long-term contracts?

A-40: The indirect costs required to be allocated to a long-term contract must be allocated to particular contracts using either a specific identification (or "tracing") method, the standard cost method, or a method using burden rates (such as ratios based on direct costs, hours, or other items, or similar formulas), so long as the method employed for such allocation reasonably allocates indirect costs among long-term contracts. The method used by the taxpayer to allocate a particular cost must be applied consistently with respect to all long-term contracts of the taxpayer. An allocation method will not be considered to be reasonable if the method does not result in the allocation (and, to the extent applicable, the capitalization) of all costs that directly benefit or are incurred by reason of the performance of the taxpayer's long-term contract activities. The taxpayer shall account for each long-term contract separately and, except as provided, both the direct and indirect costs incurred during the taxable year attributable to long-term contract activities shall be allocated to particular long-term contracts for the taxable year such costs are incurred. See Q&A-35 for special rules relating to when a cost is allocable to a contract.

X. TREATMENT OF CERTAIN CONSTRUCTION CONTRACTS

Q-41: What is a "residential construction contract" for purposes of section 460?

A-41: The term "residential construction contract" means any contract if 80 percent or more of the total estimated contract costs (as of the close of the taxable year in which the contract was entered into) are reasonably expected to be attributable to the building, construction, reconstruction, or rehabilitation of (i) dwelling units, and (ii) improvements to real property directly related to such dwelling units and located on the site of such dwelling units. All costs that are attributable to the building, construction, reconstruction, or rehabilitation under the contract of such dwelling units and improvements and that are allocable to the contract, including costs of materials and raw land, are taken into account towards meeting the 80-percent test. In the case of a contract to construct a mixed-use building (e.g., a building expected to contain both apartments and offices), the portion of costs that is attributable to construction of dwelling units (and improvements directly related to such dwelling units) is equal to the sum of (i) all costs that are attributable solely to the dwelling units (and directly related improvements), and (ii) a pro rata portion of all costs other than costs either solely attributable to the dwelling units (and directly related improvements) or solely attributable to other uses of the building (and directly related improvements). The pro rata apportionment shall be based on the relative amount of space in the building expected to be used for dwelling units. Thus, for example, if 50 percent of the total space in a mixed-use building is expected to be used for apartments, then 50 percent of the cost of land would be considered attributable to dwelling units. However, all of the expected cost of appliances to be installed only in the apartments would be considered attributable to dwelling units, because this cost is attributable solely to dwelling units.

For purposes of this Q&A-41 and for purposes of Q&A-43, the term dwelling unit has the same meaning as in section 167(k)(3)(C). Thus, a dwelling unit is a house or apartment used to provide living accommodations in a building or structure, but does not include a unit in a hotel, motel, inn, or other establishment more than one- half of the units of which are used on a transient basis.

Q-42: Which long-term contracts are exempt under section 460(e) from the requirements of section 460?

A-42: Section 460(e) provides that, except for the interest capitalization requirement of section 460(c)(3), the rules of section 460 do not apply to (1) any home construction contract entered into after June 20, 1988, and (2) any other construction contract entered into by a taxpayer (i) who estimates (at the time such contract is entered into) that such contract will be completed within the 2-year period beginning on the commencement date of such contract, and (ii) whose average annual gross receipts for the 3 taxable years preceding the year in which such contract is entered into do not exceed $10 million.

Thus, except for the interest capitalization requirements of section 460(c)(3), the law in effect before the enactment of section 460 applies to any contract described in clause (2) of the preceding paragraph, regardless of whether the contract involves the construction of a home or of commercial property. In the case of a home construction contract that is not described in clause (2) of the preceding paragraph (i.e., a contract that is not expected to be completed within two years of the commencement date, or a contract entered into by a taxpayer whose average annual gross receipts exceed $10 million), the provisions of section 263A and the regulations thereunder apply, except that the interest capitalization requirements specifically provided in section 460(c)(3) also apply. For purposes of clause (2) of the preceding paragraph, a construction contract is any contract for the building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvements of, real property. Whether a particular contract is a construction contract under this definition is to be determined by applying the rules set forth in section 1.451- 3(b)(3)(ii) of the regulations and Q&A-4.

Q-43: What is a "home construction contract" for purposes of section 460(e)?

A-43: For purposes of section 460(e) the term "home construction contract" means any construction contract if 80 percent or more of the estimated total contract costs (as of the close of the taxable year in which the contract was entered into) are reasonably expected to be attributable to the building, construction, reconstruction, or rehabilitation of (i) dwelling units (within the meaning of section 167(k)) contained in buildings (with each townhouse or rowhouse treated as a separate building) containing four or fewer units, and (ii) improvements to real property directly related to such dwelling units and located at the site of such dwelling units. All costs attributable to the building, construction, reconstruction, or rehabilitation under the contract of such dwelling units and improvements, and allocable to the contract, including costs of materials and land, are taken into account towards meeting the 80- percent test. For the treatment of a mixed-use building, see Q&A 41.

Q-44: For purposes of the 80-percent tests of Q&A-41 and Q&A-43, can costs that a developer expects to incur to construct, build, or install roads, sewers, and other common features not located on the sites of dwelling units ("off-site work") be treated as attributable to dwelling units that the developer is constructing under contract?

A-44: Yes. Assume, for example, that a developer enters into a contract for the construction and sale of a house. The costs of off- site work properly allocable to this contract are treated as attributable to the construction of the house for purposes of the 80- percent test.

Q-45: What rules apply in determining the gross receipts that are to be taken into account in applying section 460(e)(1)(B)?

A-45: For purposes of applying section 460(e), the taxpayer must take into account the gross receipts of (i) all trades or businesses (regardless of the nature of such trades or businesses) under common control with the taxpayer (within the meaning of section 52(b)), and (ii) all members of any controlled group of corporations of which the taxpayer is a member. For purposes of this determination, the term "controlled group of corporations" has the meaning given to such term by section 1563(a), except that "more than 50 percent" shall be substituted for "at least 80 percent" each place it appears in section 1563(a)(1), and the determination shall be made without regard to paragraphs (a)(4) and (e)(3)(C) of section 1563.

Persons are treated as members of controlled groups within the meaning of section 1563(a), regardless of whether such persons would be treated as "component members" of such group under section 1563(b). (See section 1.52-1(c) of the regulations.) Thus, for example, the gross receipts of a franchised corporation or a foreign corporation that is treated as an excluded member for purposes of section 1563(b) would be included for purposes of the aggregation rules of the gross receipts test under section 460(e) if the corporation and the taxpayer are members of the same controlled group under section 1563(a).

With respect to the group of persons ("members") the gross receipts of which are included in the calculation of the taxpayer's gross receipts for a taxable year, the gross receipts of the taxpayer are determined by aggregating the gross receipts of all members of the group, excluding gross receipts attributable to transactions occurring between such members. Moreover, in determining the gross receipts of any member of the group for a taxable year of less than 12 months, the gross receipts shall be annualized by (i) multiplying the gross receipts for the short period by 12, and (ii) dividing the result by the number of months in the short period.

In addition, in determining the gross receipts of the group for the three taxable years preceding the taxable year in which the contract is entered into, the gross receipts of all persons (or their predecessors) who are members of the group as of the first day of the taxable year in which the contract is entered into are included in such determination, regardless of whether such persons were members of the group for any of the three preceding taxable years. Similarly, the gross receipts of persons that were members of the group for any or all of the three preceding taxable years, but who (including their successors) are not members of the group as of the first day of the taxable year in which the contract is entered into, are not included for purposes of determining the taxpayer's average gross receipts.

EXAMPLE (1). Assume that a parent corporation (P) has continuously owned 100 percent of the stock of another corporation (S1) since 1983, and that P and S1 are calendar year taxpayers. S1 enters into a long-term contract in March of 1987. In addition, P acquired 100 percent of the stock of another calendar year corporation (S2) as of the beginning of business on January 1, 1987.

In determining whether S1's long-term contract is subject to the provisions of section 460, the gross receipts of P, S1, and S2 for 1984, 1985, and 1986 shall be aggregated, excluding the gross receipts attributable to transactions occurring between the three corporations. The gross receipts of S2 are taken into account because it was a member of the group on January 1, 1987.

EXAMPLE (2). Assume that a parent corporation (P) has continually owned 100 percent of the stock of two other corporations, (S1) and (S2), since 1983, and that the three corporations are calendar year taxpayers. S1's enters into a long-term contract in April of 1987. On December 31, 1986, P sells all of its stock in S2. In determining whether S1 long- term contract is subject to the provisions of section 460 for the taxable year beginning January 1, 1987, only the gross receipts of P and S1 for 1984, 1985, and 1986 shall be aggregated, excluding the gross receipts attributable to transactions occurring between the two corporations. The gross receipts of S2 are not taken into account because it was not a member of the group on January 1, 1987. Similarly, gross receipts attributable to transactions between S1 and S2 are not excluded.

In addition to the rules set forth above, the rules of section 1.451-3(b)(3)(iii) of the regulations (to the extent not inconsistent with the rules set forth above) relating to the determination, aggregation and attribution of gross receipts apply for purposes of section 460(e).

Q-46: Does the exception provided by section 460(e) apply for purposes of the alternative minimum tax?

A-46: Section 56(a)(3) provides, in general, that the percentage of completion method of accounting (as modified by section 460) shall be used in determining the alternative minimum taxable income ("AMTI") of a taxpayer for all long-term contracts entered into on or after March 1, 1986, for taxable years beginning after December 31, 1986. This general rule does not apply, however, to any home construction contract that both (i) is entered into after June 21, 1988, and (ii) meets the requirements of section 460(e)(1)(B) (i.e., the taxpayer estimates that such contract will be completed within the 2-year period beginning on the contract commencement date, and the taxpayer's average annual gross receipts for the three taxable years preceding the taxable year in which such contract is entered into do not exceed $10 million). Therefore, except for such home construction contracts, the requirement to use the percentage of completion method under section 56(a)(3) applies to all long-term contracts of the taxpayer, even if the contracts are exempted under section 460(e)(1) from the requirement to use the percentage of completion method or percentage of completion-capitalized cost method for regular tax purposes.

Under section 56(a)(3), as amended by section 1007(b)(1) of the 1988 Act, however, the percentage of contract completion for any contract described in section 460(e)(1) shall be determined using the simplified cost-to-cost method. (See Q&A-22 for a discussion of the simplified cost-to-cost method.)

Whether or not a contract is described in section 460(e)(1), a taxpayer may elect, as provided in Notice 87-61, solely for purposes of determining percentage of completion for purposes of the alternative minimum tax, to use either (1) the methods of accounting and costs applied in computing regular tax, or (2) the methods of accounting and costs used in computing alternative minimum taxable income. See Notice 87-61 for procedures for making this election.

XI. CHANGES IN METHODS OF ACCOUNTING

Q-47: If, as a result of the amendment of section 460 by the 1988 Act, a taxpayer wishes to change from the percentage of completion-capitalized cost method to the percentage of completion method, in what circumstances may the taxpayer do so without obtaining the consent of the Commissioner?

A-47: For purposes of section 460 of the Code, any taxpayer using a method of accounting other than the percentage of completion method as its normal method of accounting for long-term contracts (e.g., a taxpayer using the completed contract, cash or an accrual method of accounting) may automatically change its method of accounting to the percentage of completion method (including, if elected, the simplified cost-to-cost method) for --

1) all items under all long-term contracts entered into by the taxpayer after June 20, 1988; or

2) all items under all long-term contracts entered into by the taxpayer after October 13, 1987; or

3) all items under all long-term contracts entered into by the taxpayer after February 28, 1986.

The effect of alternative (2), regarding contracts entered into after October 13, 1987, is to extend the time period set forth in Notice 88-66 within which taxpayers may elect to use the percentage of completion method for all such contracts. The effect of alternative (3), regarding contracts entered into after February 28, 1986, is to extend the period, initially set forth in Notice 87-61, within which taxpayers may elect to use the percentage of completion method for all such contracts. Thus, for example, a taxpayer may use the percentage of completion-capitalized cost method for all contracts entered into after February 28, 1986 and before June 21, 1988, and may, under the terms of this notice, automatically (i.e., without requesting the consent of the Commissioner) change its method of accounting to the percentage of completion method for all long- term contracts entered into after June 20, 1988. Alternatively, a taxpayer may, under the terms of this notice, use the percentage of completion-capitalized cost method for all contracts entered into after February 28, 1986, and before October 14, 1987, and may, under the terms of this notice, automatically change its method of accounting to the percentage of completion method for all items under all contracts entered into after October 13, 1987. In addition, a taxpayer may, under the terms of this notice, use the percentage of completion method for all items under all long-term contracts entered into after February 28, 1986.

This automatic change in method of accounting for long-term contracts is conditioned on the filing of an amended return for any affected tax year for which a Federal income tax return has been filed (subject to the applicable statute of limitations). The period for filing amended returns for taxpayers changing their method of accounting to the percentage of completion method is provided in Q&A- 49 of this notice. Any taxpayer changing its method under this Q&A-47 must follow the notification procedures in Q&A-49.

Any automatic change to a method of accounting permitted under this Q&A-47 shall be effectuated by using a "cut-off" method with respect to contracts entered into after February 28, 1986, or October 13, 1987, or June 20, 1988, as the case may be. Thus, there is no change in the accounting method used with respect to any contract entered into before the applicable effective date, and the taxpayer shall not compute a section 481(a) adjustment with respect to its use of the new method of accounting.

Any change in method of accounting to the percentage of completion method other than a change for --

1) all items under all long-term contracts entered into by the taxpayer after February 28, 1986, or

2) all items under all long-term contracts entered into by the taxpayer after October 13, 1987, or

3) all items under all long-term contracts entered into by the taxpayer after June 20, 1988,

will constitute a change in method of accounting that requires the consent of the Commissioner. For example, if a calendar year taxpayer wishes to change from the percentage of completion-capitalized cost method to the percentage of completion method for its taxable year beginning on January 1, 1989, such taxpayer is required to obtain the consent of the Commissioner with respect to such change in method of accounting. Moreover, in such a situation, any change in method of accounting approved by the Commissioner (and any resulting section 481(a) adjustment) shall not consist, in whole or in part, of a change in method of accounting required to initially comply with section 460. Therefore, any resulting adjustment computed pursuant to section 481(a) shall relate only to a change from one proper method under section 460 to another proper method under section 460. See Q&A-13 for rules regarding taxpayers that had not complied with section 460 prior to requesting a change in their method of accounting for long-term contracts.

Q-48: What procedures should taxpayers follow to effectuate (1) the change in the percentage of completion-capitalized cost method of accounting from the 70/30 method to the 90/10 method required by the 1988 Act, and (2) the change in method of accounting for home construction contracts pursuant to the 1988 Act?

A-48: These changes shall be effectuated by using a "cut-off" method with respect to contracts entered into after June 20, 1988, i.e., the taxpayer shall not change its method of accounting for contracts entered into before June 21, 1988, and no adjustment under section 481(a) of the Code shall be computed. Taxpayers making these changes shall follow the notification procedures in Q&A-49 of this notice.

Q-49: What notification and filing procedures should be followed by taxpayers changing methods of accounting under either Q&A-47 or Q&A-48 of this notice?

A-49: Any taxpayer described in Q&A-47 or Q&A-48 of this notice shall complete and file a statement notifying the Internal Revenue Service of its use of the various methods of accounting (including the simplified cost-to-cost method) permitted under this notice with the taxpayer's Federal income tax return for the first taxable year ending after June 20, 1988, for which the taxpayer is required to account under section 460 for long-term contracts. The taxpayer shall type or legibly print the following language at the top of the statement required to be filed:

"NOTIFICATION PROCEDURES UNDER SECTION XI OF NOTICE 89-15". Any amended return filed by a taxpayer for the purpose, in whole or in part, of changing the taxpayer's method of accounting under Q&A-47 must be filed on or before August 14, 1989. The taxpayer shall type or legibly print the following language at the top of each amended return:

"NOTIFICATION PROCEDURES UNDER SECTION XI OF NOTICE 89-15". Notwithstanding the requirements of the preceding paragraph, if a taxpayer has (i) filed a Federal income tax return on which the statement described in the preceding paragraph was required to be included, (ii) failed to file the statement described in the preceding paragraph with such return, and (iii) otherwise properly used the method of accounting as required or allowed under this notice (including Q&A-47 and Q&A-48), the taxpayer may file a statement indicating the use of its method of accounting under the following procedures. This statement must be attached to the taxpayer's first Federal income tax return filed after May 15, 1989, for which the taxpayer is required to account under section 460 for long-term contracts. (A taxpayer, at its option, may attach the statement with any return filed before May 16, 1989.) The taxpayer shall type or legibly print the following language at the top of the statement required to be filed: "NOTIFICATION PROCEDURES UNDER SECTION XI OF NOTICE 89-15".

PROCEDURAL INFORMATION

This notice serves as an "administrative pronouncement" as that term is described in section 1.6661-3(b)(2) of the regulations and may be relied upon to the same extent as a revenue ruling or a revenue procedure. It is expected that provisions of this notice will be included in forthcoming regulations to be issued under section 460. The Commissioner invites comments concerning the issues addressed in this notice, and other issues arising under section 460.

FOR FURTHER INFORMATION

For further information regarding this notice, contact Paulette C. Galanko at (202) 566-3731 or Carol Conjura at (202) 566-3024 (neither is a toll-free call).