COMMERCIAL REAL PROPERTY CONTRACTOR MAY USE DIFFERENT METHODS TO ACCOUNT FOR LONG-TERM CONTRACTS.

Rev. Rul. 92-28

ISSUE

How does a taxpayer report income from long-term contracts if the taxpayer has both long-term contracts that are exempt under section 460(e) of the Internal Revenue Code from required use of the section 460(b) percentage of completion method ("exempt contracts") and long-term contracts that are subject to mandatory use of the section 460(b) percentage of completion method ("nonexempt contracts")?

FACTS

Situation (1)

X, a calendar-year taxpayer, is engaged in the construction of commercial real property under long-term contracts within the meaning of section 460(f) of the Code. Since X began business, its long-term contracts have all been completed within a 24-month period. As of the beginning of 1991, X's annual gross receipts have never exceeded $10,000,000. X has used the completed contract method as described in section 1.451-3(d) of the Income Tax Regulations for all long-term contracts since it began business and, as permitted by section 460(e)(1), has continued to use this method for all long-term contracts entered into after February 28, 1986. As of the beginning of 1992, X's average annual gross receipts for the 3 immediately preceding taxable years exceeded $10,000,000.

Situation (2)

Y, a calendar-year taxpayer, is engaged in the construction of commercial real property under long-term contracts within the meaning of section 460(f) of the Code. Prior to the end of 1991, Y was a member of the G controlled group of corporations (as defined in section 460(e)(3)). While Y's own annual gross receipts never exceeded $10,000,000, the G group's combined annual gross receipts always exceeded $10,000,000. Historically, Y's long-term contracts have taken from 12 to 36 months to complete. Y used the completed contract method as described in section 1.451-3(d) of the regulations for all long-term contracts entered into before March 1, 1986. Y was required by section 460 to use the percentage of completion- capitalized cost method (using the completed contract method as its normal method) for all contracts entered into after February 28, 1986, and before July 11, 1989, and to use the section 460(b) percentage of completion method for all contracts entered into after July 10, 1989.

At the end of 1991, Y became disaffiliated from the G Group. Consequently, with respect to 1992, Y's average annual gross receipts for the 3 immediately preceding taxable years did not exceed $10,000,000. See Notice 89-15, 1989-1 C.B. 816, Q & A-45. During 1992, Y entered into several long-term contracts within the meaning of section 460(f) of the Code. Y estimated that some of these contracts would be completed within a 24-month period, but that some would take longer than 24 months to complete.

LAW AND ANALYSIS

Section 446(a) of the Code provides that taxable income shall be computed under the method of accounting on the basis of which a taxpayer regularly computes its income in keeping its books. The term "method of accounting" is defined in section 1.446-1(a)(1) of the regulations to include not only a taxpayer's over-all method of accounting, but also its accounting treatment of any item. Section 1.446-1(e)(1) provides that a taxpayer may adopt any proper method of accounting in connection with each separate and distinct trade or business, the income from which is reported for the first time.

Section 446(e) of the Code and section 1.446-1(e) of the regulations provide that, except as otherwise provided, a taxpayer that has adopted a method of accounting must obtain the consent of the Commissioner in order to change to another method of accounting. See also section 1.451-3(f).

Section 460 of the Code provides the accounting rules for long- term contracts entered into after February 28, 1986. Under section 460(f), a long-term contract is defined as any contract for the manufacture, building, installation, or construction of property that is not completed within the taxable year the contract is entered into.

For long-term contracts entered into after July 10, 1989, section 460(a) of the Code provides that income must be reported under the percentage of completion method of section 460(b). For long-term contracts entered into after February 28, 1986, and before July 11, 1989, section 460(a) provided that income from a long-term contract must be reported under the section 460(b) percentage of completion method or the percentage of completion-capitalized cost method. For long-term contracts entered into before March 1, 1986, a taxpayer could adopt any proper method of accounting in accordance with section 446 and section 1.446-1(e) of the regulations, including one of the two long-term contract methods available in section 1.451-3.

Under the section 460(b) percentage of completion method, income from a long-term contract is reported on the basis of the percentage of the contract completed during each year of the contract, determined by comparing costs allocated to the contract and incurred before the close of the taxable year with the estimated total contract costs.

Under the percentage of completion-capitalized cost method formerly provided in section 460(a) of the Code, a specified percentage of the income from a long-term contract is reported under the section 460(b) percentage of completion method, and the remaining percentage of income from the contract is reported under any proper method of accounting (the taxpayer's "normal" method of accounting) for long-term contracts as determined without regard to section 460 (e.g., the completed contract method). Notice 89-15, Q & A-18, provides that, if a taxpayer accounted for long-term contracts prior to the enactment of section 460, the taxpayer's normal method of accounting is the method of accounting 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.

Section 1.451-3 of the regulations permits an eligible taxpayer to adopt one of two long-term contract methods (in lieu of using another proper method of accounting) with respect to its long-term contracts. An eligible taxpayer can elect either the percentage of completion method of section 1.451-3(c) or the completed contract method of section 1.451-3(d) as its method of accounting with respect to long-term contracts. To adopt either of these methods, a taxpayer must attach a statement to its income tax return as set forth in section 1.451-3(a)(2).

Under the percentage of completion method within section 1.451-3(c) of the regulations, a taxpayer is required to include in gross income for a taxable year the portion of the gross contract price which corresponds to the percentage of the entire contract which has been completed during that year (such percentage being determined by comparing either costs incurred with estimated total contract costs or work performed with estimated total work to be performed). Alternatively, a taxpayer using the section 1.451-3(d) completed contract method is required to report gross income from a long-term contract and all costs properly allocable to the contract in the taxable year in which the contract is completed.

Section 460(e)(1) of the Code provides, generally, that (A) any home construction contract, or (B) any other construction contract estimated to be completed within a 24-month period by a taxpayer with average annual gross receipts of not more than $10,000,000 for the 3 taxable years preceding the taxable year the contract is entered into (any "exempt contract"), is not subject to the percentage of completion method or percentage of completion-capitalized cost method requirements of section 460(a). For exempt contracts meeting the conditions of section 460(e)(1), a taxpayer may adopt any proper method of accounting, including, for example, an accrual method, a long-term contract method prescribed in section 1.451-3 of the regulations, or the section 460(b) percentage of completion method.

The method of accounting requirements of section 460(a) of the Code only apply to contracts entered into after the effective date of section 460. Therefore, taxpayers continue to use their previous method of accounting, if any, for long-term contracts entered into before the effective date of section 460.

Under the above requirements of section 446 of the Code and Section 1.446-1 of the regulations, and except as otherwise provided under section 1.451-3, a taxpayer must consistently apply an adopted method of accounting for long-term contracts to all long-term contracts within the same trade or business section 1.451-3(a)(1) provides an exception to this general rule whereby a taxpayer that has long-term contracts of substantial duration and long-term contracts of less than substantial duration within the same trade or business may report the income from all its contracts of substantial duration consistently on the same long-term contract method (e.g., the completed contract method) and report the income from all its contracts of less than substantial duration consistently pursuant to another proper method of accounting (e.g., an accrual method). Moreover, section 1.451-3 provides different methods of allocatIng costs to contracts, depending upon whether or not the contract is classified as an extended period long-term contract. See section 1.451-3(b)(3).

Similar to section 1.451-3(a)(1) of the regulations, section 460(e)(1) of the Code, which contemplates the simultaneous existence of both exempt contracts under section 460(e)(1) and nonexempt contracts within the same trade or business, permits the use of different methods of accounting for exempt contracts and nonexempt contracts within the same trade or business. Thus, a taxpayer may use a method of accounting such as the completed contract method for exempt contracts even though it must use the section 460(b) percentage of completion method for nonexempt contracts within the same trade or business. Because the rules of sections 1.446-1 and 1.451-3 of the regulations apply to all exempt contracts, however, a taxpayer may have only one long-term contract method of accounting for all exempt contracts within the same trade or business. Consistent with this treatment, there is no change in method of accounting, and accordingly, the Commissioner's consent is not required, when (1) a taxpayer adopts a permissible method of accounting for exempt contracts after having previously accounted for only nonexempt contracts, or (2) a taxpayer adopts a required method of accounting for nonexempt contracts after having previously accounted for only exempt contracts.

In accordance with the consent requirements of section 1.446-1(e) of the regulations, once a taxpayer adopts a method of accounting for long-term contracts that are not subject to the requirements of section 460(a) of the Code, the taxpayer must continue that method of accounting until the taxpayer obtains the consent of the Commissioner to change its method of accounting. Thus, absent the Commissioner's consent to make its change, if a taxpayer accounted for long-term contracts prior to the effective date of section 460, the taxpayer must continue to use its prior method of accounting for any exempt contracts that are entered into after the effective date of section 460. This result is the same even if, for a continuous period after the effective date of section 460, the taxpayer reports no income from exempt contracts.

The fact that section 460(e)(1) of the Code permits different methods of accounting to be used for exempt contracts and nonexempt contracts within a single trade or business has no effect on conclusions reached in Notice 89-15, Q & A-7, with respect to the treatment of contract classification as a method of accounting. As such, 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 of the regulations is required to account for all such contracts (and any successor contracts) as long-term contracts in applying section 460 unless the taxpayer obtains the consent of the Commissioner to change its contract classification method of accounting.

Situation (1)

All of X's long-term contracts entered into before 1992 are exempt contracts within the meaning of section 460(e)(1) of the Code. Because X's average annual gross receipts for the 3 taxable years immediately preceding 1992 exceeded $10,000,000, all of X's contracts entered into in 1992 are nonexempt contracts. Accordingly, X must use the section 460(b) percentage of completion method for all long-term contracts entered into in 1992. Because section 460(e)(1) permits different methods of accounting to be used for exempt contracts and nonexempt contracts within a single trade or business, X's adoption of the section 460(b) percentage of completion method for all long-term contracts entered into in 1992 does not constitute a change in method of accounting. X is required to continue using the completed contract method for contracts entered into before 1992, unless the Commissioner consents to a change in method of accounting for such contracts.

Situation (2)

Because Y's average annual gross receipts for the 3 taxable years immediately preceding 1992 did not exceed $10,000,000, Y's contracts entered into in 1992 that it estimates will be completed within a 24-month period are exempt contracts within the meaning of section 460(e)(1) of the Code. However, Y's contracts entered into in 1992 that it estimates will take longer than 24 months to complete are nonexempt contracts. The nonexempt contracts are subject to the requirements of section 460(a), and Y is required to use the section 460(b) percentage of completion method for these contracts. Because section 460(e)(1) permits different methods of accounting to be used for exempt contracts and nonexempt contracts within a single trade or business and because Y's historic method of accounting for exempt contracts is the completed contract method of accounting (i.e., Y's method of accounting prior to the effective date of section 460), Y must use the completed contract method of accounting for exempt contracts entered into in 1992, unless Y obtains the consent of the Commissioner to change its method of accounting in accordance with the requirements of section 1.446-1(e) of the regulations.

HOLDING

For purposes of section 446 of the Code, section 460(e)(1) permits a taxpayer to use different methods of accounting for exempt contracts under section 460(e)(1) (which are not subject to mandatory use of the section 460(b) percentage of completion method) and contracts under section 460(a) (which are subject to mandatory use of the percentage of completion method) within the same trade or business. Accordingly, a taxpayer with both exempt contracts and nonexempt contracts within the same trade or business may use a method of accounting other than the section 460(b) percentage of completion method for all exempt contracts, even though the taxpayer must use the section 460(b) percentage of completion method for all nonexempt contracts.

DRAFTING INFORMATION

The principal author of this revenue ruling is Carol Conjura, formerly of the Office of Associate Chief Counsel (Domestic). For further information regarding this revenue ruling, contact Leo F. Nolan II on (202) 535-9363 (not a toll-free call).