SERVICE ISSUES GUIDANCE CONCERNING CHANGE IN ACCOUNTING METHOD FOR LONG-TERM CONTRACTS.

Notice 87-61

This notice provides guidance with respect to certain provisions regarding the accounting for long-term contracts enacted into law by the Tax Reform Act of 1986 (the "Act") Pub. L. No. 99-514, 100 Stat. 2085. In particular, this notice relates to the procedures by which taxpayers may change their methods of accounting for long-term contracts for purposes of section 460 of the Internal Revenue Code of 1986. In addition, this notice provides an elective, simplified method for determining the percentage of completion with respect to long-term contracts under sections 460 and 56 of the Code.

I. Background.

Section 460 provides that, in the case of a long-term contract, amounts are to be taken into account using (i) the percentage of completion -- capitalized cost method, or (ii) the percentage of completion method (as modified by section 460). Section 460 is effective for long-term contracts entered into by the taxpayer after February 28, 1986, beginning with the taxpayer's first taxable year ending after such date. However, with the exception of the interest capitalization requirements of section 460(c)(3), section 460 does not apply to any contract for the construction of real property entered into by a taxpayer if (i) the taxpayer reasonably estimates (at the time the contract is entered into) that the contract will be completed within the 2-year period beginning on the contract's commencement date; and (ii) the taxpayer's average annual gross receipts for the 3 taxable years preceding the taxable year in which the contract is entered into do not exceed $10,000,000.

Under the percentage of completion method (as modified by section 460), the taxpayer is required to determine the percentage of completion with respect to each long-term contract under the "cost- to-cost" method. For purposes of the cost-to-cost method, the percentage of completion is determined by dividing the cumulative amount of contract costs incurred through the end of the taxable year by the total expected contract costs. (Contract costs are defined under section 460(c) as all costs which directly benefit or are incurred by reason of the long-term contract activities of the taxpayer). The cumulative amount of income earned under the contract through the end of the taxable year equals the percentage of the contract completed, multiplied by the expected contract price. The amount of income recognized for the taxable year is equal to the cumulative amount of income earned with respect to the contract through the end of the taxable year, decreased by the total amount of income with respect to the contract that was recognized by the taxpayer in previous taxable years. Moreover, under the percentage of completion method (as modified by section 460), the "look-back method" as described in section 460(b)(3) shall apply to all long- term contracts of the taxpayer to which section 460 applies.

For taxpayers using the percentage of completion capitalized cost method of accounting for long-term contracts, 40 percent of the items with respect to each contract are to be taken into account using the percentage of completion method (as modified by section 460), and 60 percent of the items with respect to each contract are to be taken into account under the taxpayer's "normal" method of accounting for long-term contracts, subject to the requirements of section 460, including the cost allocation requirements of section 460(c). The cost allocation requirements of section 460(c) require the capitalization of costs that directly benefit or are incurred by reason of, the long-term contract activities of the taxpayer. For purposes of section 460, a taxpayer's normal method of accounting for long-term contracts is the method the taxpayer was using to account for long-term contracts immediately prior to the effective date of section 460.

II. Taxpayers Previously Using Percentage of Completion.

Any taxpayer previously reporting income from long-term contracts using the percentage of completion method immediately prior to the effective date of section 460 shall use the percentage of completion method (as modified by section 460) for all items under all long-term contracts entered into by the taxpayer after February 28, 1986, beginning with the taxpayer's first taxable year ending after such date. If, for example, a taxpayer was previously determining the percentage of the contract completed by comparing, as of the end of the taxable year, the work performed on the contract with the estimated total work to be performed (the "engineering cost method"), then such taxpayer shall use the percentage of completion method (as modified by section 460) for all contracts entered into after February 28, 1986. Thus, the taxpayer will be required to use the cost-to-cost method of determining the percentage of the contract completed for 100 percent of the items under each long-term contract, in addition to using the look-back method with respect to each contract.

Similarly, if a taxpayer was previously determining the percentage of the contract completed by using the cost-to-cost method allowed under prior law (see section 1.451-3(c)(2)(ii) of the Regulations), then such taxpayer shall use the cost-to-cost method under section 460, utilizing, for example, the costs required to be allocated to the contract under section 460(c), and the look-back method. (However, see section VIII, relating to the simplified cost-to-cost method.)

Taxpayers described in this section II who are required to use the percentage of completion method (as modified by section 460) shall follow the notification procedures of section VI of this notice. Any taxpayer described in this section who desires to use a method other than the percentage of completion method (as modified by section 460), shall follow the provisions of section V of this notice.

III. Taxpayers Previously Using Methods Other Than Percentage of Completion.

Any taxpayer previously reporting income from long-term contracts immediately prior to the effective date of section 460 using a method of accounting other than the percentage of completion method is required to use the percentage of completion -- capitalized cost method of accounting for all long-term contracts entered into by the taxpayer after February 28, 1986, beginning with the taxpayer's first taxable year ending after such date. (However, see section IV, relating to automatic changes to the percentage of completion method.) The requirements of this section shall apply regardless of whether the taxpayer's previous method of accounting for long-term contracts (i) was a correct method of accounting under the Code; or (ii) allocated more or fewer costs to long-term contracts than required under section 460(c). Thus, any taxpayer previously using the completed contract method to account for long-term contracts prior to the effective date of section 460 shall use the percentage of completion method (as modified by section 460) with respect to 40 percent of the items under each long-term contract, and the completed contract method (the taxpayer's "normal" method) with respect to 60 percent of the items under each long-term contract, subject to the cost allocation requirements of section 460(c). Moreover, such taxpayer shall be required to capitalize, under the completed contract method, the costs described in section 460(c) regardless of whether the taxpayer properly accounted for all costs required to be capitalized under the completed contract method of prior law.

Similarly, a taxpayer previously using an accrual method to account for long-term contracts immediately prior to the effective date of section 460 shall use the percentage of completion method (as modified by section 460) for 40 percent of the items under each contract, and the particular accrual method used by the taxpayer with respect to 60 percent of the items under each long-term contract, subject to the cost allocation requirements of section 460(c).

Finally, a taxpayer who was using the cash method of accounting to account for its long-term contracts immediately prior to the effective date of section 460 shall use the percentage of completion method (as modified by section 460) with respect to 40 percent of the items under each contract and the cash method with respect to 60 percent of the items under each long-term contract. (See section 448 of the Code which requires certain taxpayers to change from the cash method of accounting as their normal method of accounting for long- term contracts with respect to taxable years beginning after December 31, 1986).

Taxpayers described in this section III who are required to use the percentage of completion -- capitalized cost method of accounting for long-term contracts shall follow the notification procedures of section VI of this notice.

IV. Automatic Change to Percentage of Completion For All Taxpayers.

For purposes of section 460, any taxpayer (e.g., a taxpayer using the completed contract method of accounting or an accrual method of accounting as its normal method of accounting for long-term contracts) may automatically change its method of accounting to the percentage of completion method of accounting (as modified by section 460) for all items under all long-term contracts entered into by the taxpayer after February 28, 1986, beginning with the taxpayer's first taxable year ending after such date. Any such taxpayer shall follow the notification procedures of section VI of this notice.

V. Changes in Method of Accounting Requiring Commissioner's Consent.

Any taxpayer using the percentage of completion method of accounting for long-term contracts immediately prior to the effective date of section 460 who wishes to change to any method of accounting other than the percentage of completion method (as modified by section 460) will be required to obtain the consent of the Commissioner with respect to such change in method of accounting. In addition, any change in the taxpayer's "normal" method of accounting such as a change from an accrual method to the completed contract method, from the completed contract method to an accrual method, or from one accrual method to another (e.g., a change from accrual- shipment to accrual-delivery) for long-term contracts will constitute a change in method of accounting that requires the consent of the Commissioner.

Similarly, any taxpayer who, 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 Regulations, shall be required to account for such contracts (and any successor contracts) under section 460 unless such taxpayer obtains the consent of the Commissioner to change its method of accounting. The term successor contracts, as used in the preceding sentence, shall mean 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), would be classified by such taxpayer as a long- term contract under section 1.451-3(b), regardless of whether such criteria and methods are correct.

Any taxpayer described in this section V who desires to change its method of accounting shall submit an application for change in accounting method under the administrative procedures applicable to taxpayers at the time of change, including the applicable procedures regarding the time and place of filing the application for change in method. However, with respect to any taxpayer described in this section who desires to change its method of accounting with respect to long-term contracts for any taxable year to which section 460 applies (including taxable years for which the taxpayer has previously filed a Federal income tax return), such taxpayer shall not be treated as filing the application for change in accounting method late if such application is filed with the National Office of the Internal Revenue Service on or before 180 days after the date that this notice is published in the Internal Revenue Bulletin. The taxpayer shall type or legibly print at the top of page 1 of the application for change in accounting method (Form 3115) the following statement: "Filed under Notice ___." In the case of a taxpayer receiving permission to change its methods of accounting for its first taxable year ending after February 28, 1986 under this section V, such change in method shall be effectuated by using a "cut-off" method with respect to contracts entered into after February 28, 1986, i.e., the taxpayer shall not compute a section 481(a) adjustment with respect to its use of the new method of accounting. Taxpayers receiving permission to change their methods of accounting may be required, under appropriate circumstances, to file amended Federal income tax returns reflecting the new method of accounting for the year of change.

VI. Notification Procedures for Certain Methods of Accounting.

Any taxpayer described in section II, III, IV, or VIII of this notice shall complete and file a statement notifying the Service of its use of the various methods of accounting under this notice with the taxpayer's Federal income tax return (including amended returns) for the first taxable year ending after February 28, 986, 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 VI of Notice ___. Any amended return filed for the purpose, in whole or in part, of changing a taxpayer's method of accounting as described in sections IV or VIII of this notice must be filed on or before 180 days after the date that this notice is published in the Internal Revenue Bulletin.

Notwithstanding the requirements of the preceding paragraph, with respect to any taxpayer who has (i) filed a Federal income tax return for the first taxable year ending after February 28, 1986 for which the taxpayer is required to account under section 460 for long- term contracts, (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 sections II, III, IV, or VIII of this notice, such taxpayer may file a statement indicating the use of its method of accounting under the following procedures. Such statement shall be attached to the taxpayer's first Federal income tax return filed subsequent to 90 days after the publication of this notice in the Internal Revenue Bulletin, for a taxable year subsequent to the first taxable year ending after February 28, 1986 for which the taxpayer is required to account under section 460 for long-term contracts. (A taxpayer, at its option, may attach such a statement with a return filed before the date described in the preceding sentence.) The taxpayer shall type or legibly print the following language at the top of the statement required to be filed: Notification Procedures under Section VI of Notice ___. Any use of a method of accounting described in this section VI shall be effectuated by using a "cut-off" method with respect to contracts entered into after February 28, 1986, i.e., the taxpayer shall not compute a section 481(a) adjustment with respect to its use of the new method of accounting.

VII. General Requirement to Use Same Method of Accounting for all Long-Term Contracts.

Under section 1.451-3(a)(1) of the Regulations, taxpayers are generally required to use the same long-term contract method of accounting for all long-term contracts within the same trade or business. This general requirement to use the same long-term contract method for all long-term contracts shall be continued under section 460 of the Code, subject to the effective date provisions of section 460 which may require the use of different methods of accounting for long-term contracts depending on whether such contracts were entered into after February 28, 1986.

Under the current Regulations, however, an exception from this rule is provided for taxpayers who have certain long-term contracts of "substantial duration" and other long-term contracts of less than substantial duration. See section 1.451-3(a)(1) of the Regulations. Under the Regulations, taxpayers may report the income from the long- term contracts of substantial duration under the same long-term contract method, while reporting the income from the long-term contracts of less than substantial duration using another proper method of accounting (e.g., an inventory method). Under section 460, taxpayers may continue this practice and utilize two different methods of accounting as their "normal" methods of accounting for six percent of the items under each long-term contract, subject to the consistency provisions of the present Regulations and subject to section 460, including the cost allocation requirements of section 460(c).

Any taxpayer who used two different methods of accounting for long-term contracts immediately prior to the effective date of section 460 is required to obtain the consent of the Commissioner if the taxpayer desires to change to the use of only one method as its "normal" method of accounting for long-term contracts. Similarly, any taxpayer who wishes to change its method of accounting to the use of two methods as its "normal" method of accounting for long-term contracts is required to obtain the consent of the Commissioner to any such change. Any taxpayer described in this paragraph who desires to change its method of accounting may, at the taxpayer's option, submit an application for a change in method of accounting under the procedures and filing deadlines provided in section V of this notice.

VIII. Simplified Method for Determining Degree of Contract Completion.

For purposes of section 460, an elective, simplified method (the "simplified cost-to-cost method") is provided herein for determining the percentage of completion under the cost-to-cost method for taxpayers using the percentage of completion method (as modified by section 460) for all items under all long-term contracts. In addition to taxpayers using the percentage of completion method, taxpayers who are properly using the cash method of accounting as their normal method of accounting for long-term contracts may use the simplified cost-to-cost method in determining percentage of completion under the cost-to-cost method for 40 percent of the items under each long-term contract. Any taxpayer properly using the cash method as its normal method of accounting for long-term contracts that uses the simplified cost-to-cost method as described herein, shall automatically change from the simplified cost-to-cost method to the cost-to-cost method under section 460 for the first taxable year that such taxpayer is required to change from the cash method of accounting under any section of the Code (including section 448). Such change shall take place under the transitional provisions of the particular section under which the taxpayer is required to change from the cash method of accounting.

Under the simplified cost-to-cost method, the following costs shall be used in determining the percentage of completion (i.e., contract costs incurred to date divided by total expected contract costs) attributable to a particular long-term contract:

(i) direct material costs and direct labor costs, as described in section 1.451-3(d)(6)(i) of the Regulations; and

(ii) 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.

Thus, a taxpayer using the simplified cost-to-cost method shall utilize the costs described in clauses (i) and (ii) above in determining both the costs allocated to the contract and incurred before the close of the taxable year, and the estimated total contract costs. Moreover, such costs shall be used by any such taxpayer under the look-back method, as described in section 460(b)(3).

Any taxpayer described in this section VIII who desires to change its method of accounting to the simplified cost-to-cost method for its first taxable year ending after February 28, 1986, shall follow the notification procedures of section VI of this notice. If the taxpayer elects to change its method of accounting to the simplified method for a year subsequent to the taxable year described in the preceding sentence, then such taxpayer shall attach a statement describing the election to use the simplified cost-to-cost method to the taxpayer's Federal income tax return for the taxable year in issue. Any such election to use the simplified cost-to-cost method shall apply only to contracts entered into on or after the first day of the year of election. Such an election shall be treated as a method of accounting, and may not be revoked without obtaining the consent of the Commissioner.

IX. Alternative Minimum Tax.

Section 56(a)(3) of the Code provides 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, with respect to taxable years beginning after December 31, 1986. The requirement to use the percentage of completion method of accounting under section 56(a)(3) applies to all long-term contracts of the taxpayer, including certain construction contracts with a duration of less than 2 years to which the provisions of section 460 do not otherwise apply.

Thus, in computing AMTI, taxpayers shall use the percentage of completion method (as modified by section 460) to account for all items under all applicable long-term contracts of the taxpayer. In addition, the cost-to-cost method under section 460 shall be used in determining the degree of completion, and the look-back method shall apply to the taxpayer's long-term contracts.

In determining the percentage of completion under the cost-to- cost method for purposes of determining AMTI, taxpayers may elect to determine their percentage of completion (i.e., cumulative contract costs incurred to date divided by total expected contract costs), using the methods of accounting and costs applied in computing regular tax ("regular methods" and "regular costs"). Thus, for example, with respect to equipment and facilities used in the performance of a particular long-term contract, a taxpayer making this election would determine the degree of completion of the contract for purposes of computing AMTI by taking into account depreciation deductions used in determining the regular tax ("regular depreciation") for both (i) the cumulative contract costs incurred through the end of the taxable year, and (ii) the total expected contract costs. In contrast, a taxpayer not electing to use this method would, in determining the degree of completion of a long-term contract for purposes of computing AMTI, calculate both cumulative contract costs incurred through the end of the taxable year, and total expected contract costs, using the depreciation methods described in section 56(a)(1) ("AMT depreciation"), including the alternative depreciation system of section 168(g).

Moreover, with respect to taxpayers having certain construction contracts with a duration of less than 2 years to which the provisions of section 460 do not otherwise apply, such taxpayers may elect to use the costs required to be capitalized under present law as it applies to such contracts in making the cost-to-cost calculations required under section 56(a)(3). In addition, taxpayers described in the preceding sentence who are properly using the cash method of accounting for long-term contracts may elect the use of the simplified cost-to-cost method as described in section VIII of this notice for purposes of section 56(a)(3).

Although taxpayers may elect to use regular methods and regular costs for purposes of calculating the degree of completion under section 56 for a long-term contract, the determination of AMTI shall be made under the provisions of section 55, including, for example, the adjustments provided in sections 56 and 58. Thus, for example, in determining AMTI with respect to a long-term contract, taxpayers shall determine their depreciation deductions using AMT depreciation under section 56(a)(1), although the degree of completion under the cost-to-cost method may have been determined using regular depreciation. The use of regular depreciation (and any other regular cost or method) for purposes of the alternative minimum tax is confined solely to the determination of the degree of completion of a long-term contract using the cost-to-cost method as described in section 460.

Taxpayers electing to use regular methods and regular costs in determining the degree of completion for long-term contracts under section 56 shall use whatever methods were used to determine the percentage of completion under section 460 for regular tax purposes. Thus, for example, an electing taxpayer shall use the simplified cost-to-cost method of determining its percentage of completion under section 56, if such taxpayer has used this method under section 460 in determining its regular tax. An electing taxpayer not using the simplified cost-to-cost method under section 460 shall use the costs described in section 460(c) in determining the degree of completion for long-term contracts under section 56.

"Any taxpayer who elects to use regular methods and regular costs in determining the degree of completion for long-term contracts under section 56, shall note such election on the taxpayer's Federal income tax return for the first taxable year in which the taxpayer (i) is subject to the alternative minimum tax as amended by the Act, and (ii) computes income from a long-term contract under section 56 using the percentage of completion method. Such election shall be treated as a method of accounting, and shall not be revoked without obtaining the consent of the Commissioner.

Any taxpayer desiring to change to this method of accounting for a subsequent year shall submit an application for change in accounting method under the administrative procedures applicable to taxpayers at the time of change, including the applicable procedures regarding the time and place of filing the application for change in method.

This notice has been submitted to the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1980 and has been approved by OMB (Control Number 1545-1011).