Final Regulation_208156-91

Federal Register / Vol. 66, No. 8 / Thursday, January 11, 2001 / Rules and Regulations

26 CFR Parts 1 and 602

become material in the administration
of any internal revenue law. Generally,
tax returns and tax return information
are confidential, as required by 26
U.S.C. 6103.

[TD 8929]

Background

RIN 1545–AQ30

Section 460, which was enacted by
section 804 of the Tax Reform Act of
1986, Public Law 99–514 (100 Stat.
2085, 2358–2361), generally requires a
taxpayer to determine the taxable
income from a long-term contract using
the percentage-of-completion method.
Section 460 was amended by section
10203 of the Omnibus Budget
Reconciliation Act of 1987, Public Law
100–203 (101 Stat. 1330, 1330–394); by
sections 1008(c) and 5041 of the
Technical and Miscellaneous Revenue
Act of 1988, Public Law 100–647 (102
Stat. 3342, 3438–3439 and 3673–3676);
by sections 7621 and 7811(e) of the
Omnibus Budget Reconciliation Act of
1989, Public Law 101–239 (103 Stat.
2106, 2375–2377 and 2408–2409); by
section 11812 of the Omnibus Budget
Reconciliation Act of 1990, Public Law
101–508 (104 Stat. 1388, 1388–534 to
1388-536); by sections 1702(h)(15) and
1704(t)(28) of the Small Business Job
Protection Act of 1996, Public Law 104–
188 (110 Stat. 1755, 1874, 1888); and by
section 1211 of the Taxpayer Relief Act
of 1997, Public Law 105–34 (111 Stat.
788, 998–1000).
Section 460(h) directs the Secretary to
prescribe regulations to the extent
necessary or appropriate to carry out the
purpose of section 460, including
regulations to prevent a taxpayer from
avoiding section 460 by using related
parties, pass-through entities,
intermediaries, options, and other
similar arrangements.
On May 5, 1999, the IRS and Treasury
Department published a notice of
proposed rulemaking (64 FR 24096
[REG–208156–91, 1999–22 I.R.B. 11])
relating to section 460. Comments
responding to the notice were received,
and a public hearing was scheduled for
September 14, 1999.
The IRS and Treasury Department
received eleven comment letters
concerning the notice of proposed
rulemaking. After considering the
comments contained in these letters, the
IRS and Treasury Department adopt the
proposed regulations as revised by this
Treasury decision. The comments and
revisions are discussed below.

DEPARTMENT OF THE TREASURY
Internal Revenue Service

Accounting for Long-Term Contracts
AGENCY: Internal Revenue Service (IRS),
Treasury.
ACTION: Final regulations.
SUMMARY: This document contains final
regulations describing how income from
a long-term contract must be accounted
for under section 460 of the Internal
Revenue Code, which was enacted by
the Tax Reform Act of 1986. A taxpayer
manufacturing or constructing property
under a long-term contract will be
affected by these regulations.
DATES: Effective Date: These regulations
are effective on January 11, 2001.
Applicability Date: These regulations
apply to any contract entered into on or
after January 11, 2001.
FOR FURTHER INFORMATION CONTACT: Leo
F. Nolan II or John M. Aramburu of the
Office of Associate Chief Counsel
(Income Tax and Accounting) at (202)
622–4960 (not a toll-free number).
SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act
The collection of information
contained in these final regulations has
been reviewed and approved by the
Office of Management and Budget in
accordance with the Paperwork
Reduction Act of 1995 (44 U.S.C.
3507(d)) under control number 1545–
1650. Responses to this collection of
information are mandatory.
An agency may not conduct or
sponsor, and a person is not required to
respond to, a collection of information
unless it displays a valid control
number assigned by the Office of
Management and Budget.
The estimated annual burden per
respondent and/or recordkeeper is 15
minutes.
Comments concerning the accuracy of
this burden estimate and suggestions for
reducing this burden should be sent to
the Internal Revenue Service, Attn: IRS
Reports Clearance Officer,
W:CAR:MP:FP:S:O, Washington, DC
20224, and to the Office of Management
and Budget, Attn: Desk Officer for the
Department of the Treasury, Office of
Information and Regulatory Affairs,
Washington, DC 20503.
Books or records relating to a
collection of information must be
retained as long as their contents might

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Explanation of Provisions
1. Overview
Section 460 generally requires the
income from a long-term contract to be
determined using the percentage-of-

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completion method based on a cost-tocost comparison (PCM). However, the
income from exempt construction
contracts still may be determined using
the completed-contract method (CCM),
the exempt-contract percentage-ofcompletion method (EPCM), or any
other permissible method. Contracts
that are not long-term contracts must be
accounted for using a permissible
method of accounting other than a longterm contract method (i.e., a method
other than the PCM, the CCM, or the
EPCM). See section 446 and the
regulations thereunder.
One commentator suggested that the
exceptions to the mandatory use of the
PCM included in the proposed
regulations be expanded to include ‘‘any
portion of the long-term manufacturing
contract for which no payment for the
manufacture of the subject matter of the
contract is required to be made before
the manufacture of the item is
completed.’’ The exceptions contained
in the proposed regulations were
specifically provided by the statute and
the statute does not include the
suggestion made by the commentator.
Thus, the IRS and Treasury Department
did not adopt this suggestion.
2. Definition of Long-Term Contract
Under section 460(f), ‘‘long-term
contract’’ generally means any contract
for the building, installation,
construction (construction), or the
manufacture, of property if the contract
is not completed within the taxable year
the taxpayer enters into the contract
(contracting year). However, a
manufacturing contract is not a longterm contract unless it involves the
manufacture of (1) a unique item of a
type that is not normally included in the
finished goods inventory of the taxpayer
or (2) an item normally requiring more
than 12 calendar months to complete,
regardless of the duration of the
contract.
Continuing the policy established in
Notice 89–15 (1989–1 C.B. 634), the
proposed regulations provide that it is
not relevant whether the customer has
title to, control over, or risk of loss with
respect to the property. One
commentator suggested that the final
regulations should not retain the rule
that requires a contractor to ignore title
and risk-of-loss issues relative to the
applicability of section 460 because a
contractor has little freedom to
restructure a contract to ‘‘construct’’
into a contract to ‘‘sell.’’ The IRS and
Treasury Department did not adopt this
suggestion because we believe that a
contract’s classification should be based
on the performance required of the
taxpayer under the contract regardless

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Federal Register / Vol. 66, No. 8 / Thursday, January 11, 2001 / Rules and Regulations

of whether that contract otherwise
would be classified as a sales contract
or a construction or manufacturing
contract. Moreover, the IRS and
Treasury Department continue to
believe that the rule in the proposed
regulations is necessary to prevent a
taxpayer from circumventing section
460 by structuring a construction
contract to resemble a sales contract
without changing the taxpayer’s
obligations under the contract. Another
commentator asked whether a contract
is subject to section 460 if it requires the
taxpayer to manufacture or construct
property in order to fulfill its
contractual obligation but the property
is never delivered to the customer (e.g.,
a research contract for test results).
Again, the IRS and Treasury Department
believe that a contract’s classification
should depend upon the performance
required of the taxpayer under the
contract. Thus, the final regulations
clarify that it is irrelevant whether title
in the property manufactured or
constructed under the contract is
delivered to the customer.
The proposed regulations provide that
a contract is not a construction contract
if it requires the taxpayer to provide
land to the customer and the estimated
total allocable contract costs attributable
to the taxpayer’s construction activities
are less than 10 percent of the contract’s
total contract price. One commentator
asked for clarification concerning
whether the estimated total allocable
contract costs attributable to the
taxpayer’s construction activities
includes the cost of the land provided
under the contract. The final regulations
clarify that the cost of this land is not
an allocable contract cost when the
taxpayer determines whether the cost of
its construction activities is less than 10
percent of the contract’s total contract
price.
3. Date Taxpayer Completes a LongTerm Contract
The proposed regulations provide that
a long-term contract is completed in the
earlier taxable year (completion year)
that: (1) The customer uses the subject
matter of the contract (other than for
testing) and at least 95 percent of the
total allocable contract costs attributable
to the subject matter have been incurred
by the taxpayer; or (2) the subject matter
of the contract is finally completed and
accepted. To the extent that the
‘‘customer-use’’ rule requires a taxpayer
to treat a contract as completed before
final completion and acceptance have
occurred, the proposed regulations
explicitly adopt a rule different from
that considered in Ball, Ball and
Brosamer, Inc. v. Commissioner, 964

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F.2d 890 (9th Cir. 1992), aff’g T.C.
Memo. 1990–454.
Some commentators argued against
having a rule that will declare a contract
completed earlier than under the
finally-completed-and-accepted
standard illustrated in Ball. Some
commentators also argued that the
customer-use rule is confusing to
subcontractors because it is unclear
whether a subcontractor’s ‘‘customer’’ is
the general, or ‘‘prime,’’ contractor or
the ultimate owner of the property. On
the other hand, one commentator asked
for a bright-line standard for completion
and suggested, among other
possibilities, that completion occur
when 95 percent of the estimated costs
have been incurred.
The IRS and Treasury Department
continue to believe that a contract is
complete for all practical purposes
when the customer uses the subject
matter of that contract and the taxpayer
has only five percent or less of the total
allocable contract costs remaining to be
incurred. Delaying a contract’s
completion beyond this point, as the
Tax Court permitted in Ball, does not
reflect the substance of the transaction
and could encourage the use of
formalities to delay a contract’s
completion unreasonably. Thus, the
final regulations do not substantively
change the customer-use rule contained
in the proposed regulations. However,
the final regulations clarify that a
subcontractor’s customer is the general
contractor.
Several commentators expressed
concern that the customer-use rule
contained in the proposed regulations
will create additional administrative
burdens for taxpayers using the PCM
because they often will have to apply
the look-back method two times, first
upon customer use and again upon final
completion and acceptance. Though the
IRS and Treasury Department believe
that the customer-use rule results in an
appropriate determination of
completion, we understand these
concerns. Thus, to simplify a taxpayer’s
reporting requirements under the lookback method, the IRS and Treasury
Department have modified the lookback regulations to require a taxpayer to
delay the first application of the lookback method until the taxable year in
which a long-term contract is finally
completed and accepted.
4. Severing and Aggregating Contracts
The proposed regulations allow the
Commissioner, and generally require a
taxpayer, to sever and aggregate
contracts when necessary to clearly
reflect income. The proposed
regulations provide the following

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criteria for determining whether
severance or aggregation is required:
Independent versus interdependent
pricing, separate delivery or acceptance,
and the reasonable businessperson
standard. However, under the proposed
regulations, a taxpayer may not sever a
contract subject to the PCM. In addition,
the proposed regulations require a
taxpayer to notify the Commissioner
when severing a long-term contract not
accounted for using the PCM and
provide agreement-specific information,
including the criteria for severing or
aggregating the agreement.
Some commentators criticized the ‘‘no
severance’’ rule for long-term contracts
subject to the PCM. The ‘‘no severance’’
rule is provided in the proposed
regulations because the IRS and
Treasury Department believe that in
most cases, a taxpayer’s use of the PCM
and look-back method will clearly
reflect the taxpayer’s income from a
long-term contract. To date, the only
identified reason to allow severance of
a contract subject to the PCM related to
the application of the 10-percent
method as shown in § 1.460–1(j)
Example 8 of the proposed income tax
regulations. Conversely, the IRS and
Treasury Department believe that
permitting a taxpayer to sever a contract
subject to the PCM could allow the
taxpayer to manipulate taxable income
(e.g., by severing to create a loss contract
and accelerate the loss) or to avoid the
application of section 460 (e.g., by
‘‘completing’’ the contract during the
contracting year). Nonetheless, the IRS
and Treasury Department agree with the
commentators’ concerns that to the
extent severance is necessary to clearly
reflect income from a long-term contract
(e.g., due to the application of the 10percent method), it should be permitted.
Accordingly, the final regulations allow
a taxpayer to sever a long-term contract
if necessary to clearly reflect income,
but only if the taxpayer has obtained the
Commissioner’s prior written consent.
Some commentators criticized the
notification requirement for severed and
aggregated contracts as being unduly
burdensome. The IRS and Treasury
Department continue to believe that
notification will help taxpayers and the
IRS consistently apply the severing and
aggregating rules. In recognition of the
potential burden associated with the
proposed notification requirement,
however, the final regulations simplify
the notification by only requiring that a
taxpayer inform the IRS when it has
severed or aggregated agreements. Thus,
the taxpayer is no longer required to
provide agreement-specific information.
One commentator suggested that the
reasonable businessperson standard be

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eliminated because it is merely a subset
of independent pricing and
interdependent pricing (the pricing
standards), which should be the primary
criteria for determining whether longterm contracts must be severed or
aggregated to clearly reflect income. The
IRS and Treasury Department agree that
the pricing standards and the reasonable
businessperson standard overlap, but
believe that the pricing standard is a
subset of the reasonable businessperson
standard. Besides requiring an analysis
of pricing, the reasonable
businessperson standard requires an
analysis of all the facts and
circumstances of the business
arrangement between the taxpayer and
the customer. Thus, because the absence
of the reasonable businessperson
standard might change the decision to
sever or aggregate in some cases, the
final regulations retain this criterion and
clarify its distinction from the pricing
standards.
5. Hybrid Contracts
Under the proposed regulations, a
taxpayer generally must classify a
contract that requires the taxpayer to
manufacture personal property and to
construct real property (hybrid contract)
as separate manufacturing and
construction contracts. If at least 95
percent of the estimated allocable
contract costs are reasonably allocable
to manufacturing (or construction)
activities, the taxpayer may classify the
contract as a manufacturing (or
construction) contract.
One commentator suggested that the
final regulations allow a taxpayer to
elect to use the PCM to account for a
hybrid contract instead of requiring the
taxpayer to account for both parts
separately. The IRS and Treasury
Department agree with the
commentator’s request for
simplification. Accordingly, the final
regulations allow a taxpayer to elect, on
a contract-by-contract basis, to classify a
hybrid contract as a long-term
manufacturing contract subject to the
PCM. In addition, because this election
effectively supersedes the 95-percent
election that would have applied to
hybrid contracts that are primarily
manufacturing contracts, the final
regulations retain the 95-percent
election as a second election that
applies only to hybrid contracts that are
primarily construction contracts.
6. Contracts of Related Parties
The proposed regulations provide that
if a related party and its customer enter
into a long-term contract subject to the
PCM, and a taxpayer performs any
activity that is incident to or necessary

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for the related party’s long-term
contract, the taxpayer must account for
the gross receipts and costs attributable
to the activity using the PCM. However,
the proposed regulations contain an
inventory exception for components and
subassemblies produced by the taxpayer
if the taxpayer regularly carries these
items in its finished goods inventories
and 80 percent or more of the gross
receipts from the sale of these items
typically comes from unrelated parties.
One commentator suggested that the
percentage threshold be lowered from
80 percent to 50 percent and that the
exception not be limited to items
regularly carried in the taxpayer’s
finished goods inventories. The IRS and
Treasury Department included the
related party rule, originally
promulgated in Notice 89–15, in the
proposed regulations to prevent
taxpayers from establishing specialpurpose subsidiaries to avoid the
application of section 460. However, in
recognition that a related party that sells
most units of a manufactured item to
unrelated parties was not established for
the purpose of avoiding section 460, the
IRS and Treasury Department added the
inventory exception to the proposed
regulations to reduce the related party’s
accounting burden. The IRS and
Treasury Department agree, however,
that the inventory exception is too
narrow. Accordingly, the final
regulations lower the percentage
threshold from ‘‘80 percent or more’’ to
‘‘more than 50 percent’’ and eliminate
the requirement that the components or
subassemblies be carried in finished
goods inventories.
7. Unique Items
Section 460 applies if a taxpayer
manufactures a unique item of a type
that is not normally included in the
finished goods inventory of the taxpayer
and if the contract is not completed by
the close of the contracting year. The
proposed regulations provide that
‘‘unique’’ means specifically designed
for the needs of a customer. In addition,
the proposed regulations contain three
safe harbors concerning contracts to
manufacture unique items. First, an
item is not unique if the taxpayer
normally completes the item within 90
days. Second, an item is not unique if
the total allocable contract costs
attributable to customizing activities
that are incident to or necessary for the
production of the item do not exceed 5
percent of the estimated total costs
allocable to the item. Third, a unique
item ceases to be unique no later than
when the taxpayer normally includes
similar items in its finished goods
inventory. For an item that does not

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satisfy one of these three safe harbors,
the determination of whether the item is
unique is based on the facts and
circumstances.
Some commentators suggested that
the final regulations contain either a
140-day or a 180-day safe harbor instead
of the 90-day safe harbor. The IRS and
Treasury Department did not adopt
these suggestions because we believe
that a 90-day safe harbor appropriately
limits the meaning of ‘‘unique’’ in most
cases. However, the IRS and Treasury
Department have modified the 90-day
safe harbor to clarify that in the case of
a contract to manufacture multiple units
of the same item, the 90-day safe harbor
applies only if each unit normally is
completed within 90 days.
Some commentators suggested that
the final regulations contain either a 10percent, 15-percent, or 20-percent safe
harbor instead of the 5-percent safe
harbor. In particular, these
commentators stated that a 5-percent
safe harbor will not alleviate any
controversy between taxpayers and
revenue agents because revenue agents
generally do not raise the issue of
unique items if the taxpayer’s
customizing costs do not exceed 5
percent. The IRS and Treasury
Department agree that it is reasonable to
assume that an item is not unique if the
taxpayer’s customizing costs do not
exceed 10 percent. Thus, the
customization safe harbor in the final
regulations has been increased to 10
percent.
One commentator suggested that the
cost of a taxpayer’s customizing
activities should not include the cost of
any customized equipment purchased
by a taxpayer from an unrelated party
under a ‘‘special accommodation’’
arrangement with the customer that
requires the taxpayer to acquire and
install that customized equipment. The
IRS and Treasury Department did not
adopt this suggestion because such a
special accommodation rule could
enable taxpayers to avoid section 460 by
having some long-term contract
activities performed by outside parties.
Several commentators questioned the
relevance of the ‘‘basic design’’ concept
included in § 1.460–2(e) Example 1 of
the proposed regulations. To determine
whether an item is unique, the relevant
analysis is whether an item is
customized (or manufactured according
to a customer’s specifications)
regardless of whether the item is
customized from a basic design.
Accordingly, the final regulations delete
the reference to the taxpayer’s basic
design in the example to eliminate any
confusion.

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One commentator questioned how the
safe harbor applies in the case of a
contract to manufacture multiple units
of the same item. The IRS and Treasury
Department believe that if significant
customization is necessary to produce
an item for a customer under the
contract, that item is specifically
designed for the needs of the customer,
and thus is a unique item, regardless of
the number of units produced for the
customer under the contract. Thus, the
final regulations clarify that for the
purposes of applying the 10-percent safe
harbor to a contract to manufacture
multiple units of the same item, a
taxpayer must allocate all customization
costs to the first unit manufactured
under the contract.
Some commentators suggested the
addition of a fourth safe harbor that
would exclude ‘‘income on contracts for
which progress payments have not been
received by year end.’’ The IRS and
Treasury Department did not adopt this
suggestion because we do not believe
that such a rule bears any relationship
to a determination of the uniqueness of
an item and because such a rule is
inconsistent with the statute.
8. 12-Month Completion Period
The proposed regulations provide that
a manufactured item normally requires
more than 12 months to complete if its
‘‘production period,’’ as defined in
§ 1.263A–12, is reasonably expected to
exceed 12 months, determined at the
end of the contracting year. In general,
the production period for an item or
unit begins when the taxpayer incurs at
least 5 percent of the estimated total
allocable contract costs, including
planning and design expenditures,
allocable to the item or unit, and the
production period ends when the item
or unit is ready for shipment to the
taxpayer’s customer.
Some commentators suggested that
the final regulations be clarified to
provide that ‘‘normal time to complete’’
includes only the time of physical
production activity and not the time of
any research, development, planning, or
design activity. The IRS and Treasury
Department did not adopt this
suggestion because we believe that the
definition of ‘‘production period’’ under
§ 1.263A–12(c)(3), which includes the
time required for planning and design
activity, is consistent with the allocation
of costs to extended-period long-term
contracts under § 1.451–3(d)(6) and with
section 460(c)(1), which requires that
costs be allocated under the rules
applicable to extended-period long-term
contracts. In addition, if an item
manufactured under a long-term
contract requires a significant amount of

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design time to produce, it is appropriate
to include the time needed to perform
these activities when determining that
item’s ‘‘normal time to complete’’
because these activities are directly
attributable to that contract and are
necessary to manufacture the subject
matter of the contract. However, the
final regulations clarify that a taxpayer
is not required to consider activities
related to costs that are not allocable
contract costs under section 460 (e.g.,
independent research and development
expenses, marketing expenses) when
determining the item’s normal time to
complete.
Some commentators asked how the
12-month rule applies in the case of a
contract to manufacture multiple units
of the same item. The final regulations
clarify, that for the purposes of applying
the 12-month rule to this type of
contract, the time required to design and
manufacture the first unit generally does
not reflect the item’s ‘‘normal time to
complete.’’ For example, the time
required to design the first unit of an
item should not be considered as time
required to manufacture subsequent
identical units. The final regulations
also include an example illustrating the
determination of normal time to
complete an item in the case of a
contract to manufacture multiple units
of the same item.
9. Percentage-of-Completion Method
The proposed regulations provide
that, under the PCM, a taxpayer
generally includes a portion of the total
contract price in income for each
taxable year that the taxpayer incurs
contract costs allocable to the long-term
contract. Under the proposed
regulations, total contract price
included all bonuses, awards, and
incentive payments if it is reasonably
estimated that they will be received,
even if the all events test has not yet
been met. If, by the end of the
completion year, a taxpayer cannot
reasonably estimate whether a
contingency will be satisfied, the bonus,
award, or incentive payment is not
includible in total contract price.
Some commentators argued that a
taxpayer should not have to include
contingent compensation in ‘‘total
contract price’’ until the all events test
for the item has been satisfied. The IRS
and Treasury Department did not adopt
this suggestion because the all events
test is a judicially created test applying
to taxpayers using an accrual method.
U.S. v. Anderson, 269 U.S. 422 (1926).
Conversely, section 460 is a selfcontained, statutorily created
accounting method that requires
taxpayers to use estimated amounts

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when computing taxable income under
the PCM and to use actual amounts
when applying the look-back method. In
addition, using the most accurate
estimate of total contract price and total
contract costs will produce the most
accurate annual reporting of income and
costs and will minimize discrepancies
that could necessitate paying look-back
interest. See Tutor-Saliba Corp. v.
Commissioner, 115 T.C. No. 1 (July 17,
2000). However, in response to
comments and questions concerning the
contingent income rule, the final
regulations provide that contingent
income is includible in total contract
price not later than when it is included
in income for financial reporting
purposes under generally accepted
accounting principles.
One commentator suggested that the
final regulations incorporate the rule
under § 1.451–3(a)(1) that allows a
taxpayer to account for long-term
contracts of less-than-substantial
duration using a method of accounting
other than a long-term contract method
of accounting. The IRS and Treasury
Department did not adopt this
suggestion because such a rule would be
inconsistent with the statutory
definition of ‘‘long-term contract.’’
One commentator asked how a
contractor should account for the
subject matter of a long-term contract
when the customer breaches that
contract before the contractor has
transferred title to the customer but after
the contractor has reported taxable
income from that contract under the
PCM (e.g., unfinished condominium
unit). In response to this comment, the
final regulations include new § 1.460–
4(b)(7), which provides that if a longterm contract is terminated before
completion and, as a result, the taxpayer
retains ownership of the property that is
the subject matter of that contract, the
taxpayer must reverse the previously
reported gross income (loss) from the
transaction in the taxable year of
termination. As a result of reversing its
previously reported gross income under
this rule, a taxpayer generally will have
an adjusted basis in the retained
property equal to its previously
deducted allocable contract costs. The
look-back method does not apply to any
terminated contract to the extent it is
subject to this rule. The IRS and
Treasury Department request
suggestions for rules that will apply
when the customer acquires ownership
of some, but not all, of the property that
is the subject matter of the contract.
10. Cost Allocation Rules
The proposed and final regulations
provide that a taxpayer generally must

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allocate costs to a contract subject to
section 460(a) in the same manner as
direct and indirect costs are capitalized
to property produced by a taxpayer
under section 263A. The regulations
provide exceptions, however, that
reflect the differences in the cost
allocation rules of sections 263A and
460.
One commentator argued that the
final regulations should contain a single
standard for determining when the cost
of a direct material is allocable to a longterm contract. In response to this
comment, the final regulations contain a
single standard linked to the uniform
capitalization (UNICAP) rules of section
263A. The final regulations also clarify
that, among other methods, a taxpayer
dedicates direct materials by associating
them with a specific contract (e.g., by
purchase order, entry on books and
records, shipping instructions).
One commentator suggested that the
final regulations clarify that taxpayers
should not treat software development
and software implementation costs as
customization costs for the purposes of
the proposed 5-percent safe harbor. The
IRS and Treasury Department did not
adopt this suggestion because we
believe that software costs are allocable
contract costs (and thus customization
costs) to the extent they are incident to
or necessary for the manufacture of the
subject matter of the contract.
This commentator also suggested that
the final regulations clarify that
taxpayers should not treat guarantee,
warranty, and maintenance costs as
customization costs for the purposes of
the proposed 5-percent safe harbor. The
IRS and Treasury Department modified
§ 1.460–1(d)(2) to clarify that these types
of costs are not allocable contract costs.
11. Simplified Cost-to-Cost Method
The proposed regulations generally
permit a taxpayer to elect to allocate
contract costs using the simplified costto-cost method. Under the simplified
cost-to-cost method, a taxpayer must
determine a contract’s completion factor
based upon only direct material costs;
direct labor costs; and depreciation,
amortization, and cost recovery
allowances on equipment and facilities
directly used to manufacture or
construct property under the contract.
One commentator suggested that the
final regulations clarify whether a
taxpayer using the simplified cost-tocost method is allowed or required to
include subcontracted costs in a
contract’s completion factor. In response
to this comment, the final regulations
clarify that subcontracted costs
represent either direct material or direct
labor costs and thus must be allocated

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to a contract under the simplified costto-cost method when incurred under
§ 1.461–4(d)(2)(ii). In addition, a
taxpayer must allocate subcontracted
costs for all section 460 purposes (e.g.,
applying the 10-percent safe harbor
under § 1.460–2(b)(2)(ii)).
12. Statute of Limitations and
Compound Interest on Look-Back
Interest
One commentator requested guidance
concerning the statute of limitations
applicable to payments of, and claims
for, look-back interest. The final
regulations amend § 1.460–6(f)(1) and
(2) to clarify the reporting requirements
and add new § 1.460–6(f)(3). New
§ 1.460–6(f)(3) provides guidance on the
statute of limitations applicable to the
assessment and collection of look-back
interest owed by a taxpayer. In addition,
new § 1.460–6(f)(3) provides that a
taxpayer’s claim for credit or refund of
look-back interest previously paid by or
collected from the taxpayer is a claim
for credit or refund of an overpayment
of tax for federal income tax purposes,
which is subject to the section 6511
statute of limitations. In contrast, new
§ 1.460–6(f)(3) provides that a taxpayer’s
claim for look-back interest (or interest
payable on look-back interest) that is not
attributable to an amount previously
paid by or collected from the taxpayer
is a general claim against the federal
government, which is subject to the
statutes of limitations found in 28
U.S.C. sections 2401 and 2501.
13. Effective Date
These final regulations apply to any
contract entered into on or after January
11, 2001.
Special Analyses
It has been determined that this
Treasury decision is not a significant
regulatory action as defined in
Executive Order 12866. Therefore, a
regulatory assessment is not required. It
also has been determined that section
553(b) of the Administrative Procedure
Act (5 U.S.C. chapter 5) does not apply
to these regulations. Pursuant to section
7805(f) of the Internal Revenue Code,
this Treasury decision was submitted to
the Chief Counsel for Advocacy of the
Small Business Administration for
comment on its impact on small
business. It is hereby certified that the
collection of information in this
Treasury decision will not have a
significant economic impact on a
substantial number of small entities.
The regulations require a taxpayer to
attach a statement to its original federal
income tax return if the taxpayer severs
or aggregates a long-term contract. The

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statement is needed so the
Commissioner can determine whether
the taxpayer properly severed or
aggregated the contract. It is uncommon
for a taxpayer that has a long-term
contract to sever or aggregate that
contract. In addition, if a contract is
severed or aggregated and a statement is
required, it is estimated that it will, on
average, require only 15 minutes to
complete.
Drafting Information
The principal author of these
regulations is Leo F. Nolan II, Office of
Associate Chief Counsel (Income Tax
and Accounting). However, other
personnel from the IRS and Treasury
Department participated in their
development.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and
recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping
requirements.
Adoption of Amendments to the
Regulations
Accordingly, 26 CFR parts 1 and 602
are amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation is
amended by removing the entry for
‘‘Section 1.451–3 and 1.451–5’’, revising
the entry for ‘‘Section 1.460–4’’, and
adding the following entries in
numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *

*

*

*

*

*

Section 1.451–5 also issued under 96 Stat.
324, 493.

*

*

*

*

*

Section 1.460–1 also issued under 26
U.S.C. 460(h).
Section 1.460–2 also issued under 26
U.S.C. 460(h).
Section 1.460–3 also issued under 26
U.S.C. 460(h).
Section 1.460–4 also issued under 26
U.S.C. 460(h) and 1502.
Section 1.460–5 also issued under 26
U.S.C. 460(h).

*

*

§ 1.446–1

*

*

*

[Amended]

Par. 2. Section 1.446–1 is amended as
follows:
1. In the second sentence of paragraph
(c)(1)(iii), the language ‘‘451’’ is
removed and ‘‘460’’ is added in its
place.
2. In the fourth sentence of paragraph
(e)(2)(ii)(a), the language ‘‘§ 1.451–3’’ is

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removed and ‘‘§ 1.460–4’’ is added in its
place.
§ 1.451–3

[Removed]

Par. 3. Section 1.451–3 is removed.
§ 1.451–5

[Amended]

Par. 4. Section 1.451–5 is amended by
removing the language ‘‘§ 1.451–3’’ and
adding ‘‘§ 1.460–4’’ in its place in the
first sentence of paragraph (b)(3).
Par. 5. Section 1.460–0 is amended
by:
1. Revising the introductory text.
2. Revising the entries for §§ 1.460–1
through 1.460–3, 1.460–4(a) through (i),
and 1.460–5.
3. Adding an entry for § 1.460–4(k).
4. Removing the entry for § 1.460–
6(c)(4)(iv).
5. Adding an entry for § 1.460–6(f)(3).
6. Removing the entries for §§ 1.460–
7 and 1.460–8.
The revisions and addition read as
follows:
§ 1.460–0 Outline of regulations under
section 460.

This section lists the paragraphs
contained in § 1.460–1 through § 1.460–
6.
§ 1.460–1 Long-term contracts.
(a) Overview.
(1) In general.
(2) Exceptions to required use of PCM.
(i) Exempt construction contract.
(ii) Qualified ship or residential construction
contract.
(b) Terms.
(1) Long-term contract.
(2) Contract for the manufacture, building,
installation, or construction of property.
(i) In general.
(ii) De minimis construction activities.
(3) Allocable contract costs.
(4) Related party.
(5) Contracting year.
(6) Completion year.
(7) Contract commencement date.
(8) Incurred.
(9) Independent research and development
expenses.
(10) Long-term contract methods of
accounting.
(c) Entering into and completing long-term
contracts.
(1) In general.
(2) Date contract entered into.
(i) In general.
(ii) Options and change orders.
(3) Date contract completed.
(i) In general.
(ii) Secondary items.
(iii) Subcontracts.
(iv) Final completion and acceptance.
(A) In general.
(B) Contingent compensation.
(C) Assembly or installation.
(D) Disputes.
(d) Allocation among activities.
(1) In general.
(2) Non-long-term contract activity.

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(e) Severing and aggregating contracts.
(1) In general.
(2) Facts and circumstances.
(i) Pricing.
(ii) Separate delivery or acceptance.
(iii) Reasonable businessperson.
(3) Exceptions.
(i) Severance for PCM.
(ii) Options and change orders.
(4) Statement with return.
(f) Classifying contracts.
(1) In general.
(2) Hybrid contracts.
(i) In general.
(ii) Elections.
(3) Method of accounting.
(4) Use of estimates.
(i) Estimating length of contract.
(ii) Estimating allocable contract costs.
(g) Special rules for activities benefitting
long-term contracts of a related party.
(1) Related party use of PCM.
(i) In general.
(ii) Exception for components and
subassemblies.
(2) Total contract price.
(3) Completion factor.
(h) Effective date.
(1) In general.
(2) Change in method of accounting.
(i) [Reserved]
(j) Examples.

(5) Completion factor.
(i) Allocable contract costs.
(ii) Cumulative allocable contract costs.
(iii) Estimating total allocable contract costs.
(iv) Pre-contracting-year costs.
(v) Post-completion-year costs.
(6) 10-percent method.
(i) In general.
(ii) Election.
(7) Terminated contract.
(i) Reversal of income.
(ii) Adjusted basis.
(iii) Look-back method.
(c) Exempt contract methods.
(1) In general.
(2) Exempt-contract percentage-ofcompletion method.
(i) In general.
(ii) Determination of work performed.
(d) Completed-contract method.
(1) In general.
(2) Post-completion-year income and costs.
(3) Gross contract price.
(4) Contracts with disputed claims.
(i) In general.
(ii) Taxpayer assured of profit or loss.
(iii) Taxpayer unable to determine profit or
loss.
(iv) Dispute resolved.
(e) Percentage-of-completion/capitalized-cost
method.
(f) Alternative minimum taxable income.
(1) In general.
(2) Election to use regular completion factors.
(g) Method of accounting.
(h) Examples.
(i) [Reserved]

§ 1.460–2 Long-term manufacturing
contracts.
(a) In general.
(b) Unique.
(1) In general.
(2) Safe harbors.
(i) Short production period.
(ii) Customized item.
(iii) Inventoried item.
(c) Normal time to complete.
(1) In general.
(2) Production by related parties.
(d) Qualified ship contracts.
(e) Examples.

*

§ 1.460–3 Long-term construction
contracts.
(a) In general.
(b) Exempt construction contracts.
(1) In general.
(2) Home construction contract.
(i) In general.
(ii) Townhouses and rowhouses.
(iii) Common improvements.
(iv) Mixed use costs.
(3) $10,000,000 gross receipts test.
(i) In general.
(ii) Single employer.
(iii) Attribution of gross receipts.
(c) Residential construction contracts.
§ 1.460–4 Methods of accounting for longterm contracts.
(a) Overview.
(b) Percentage-of-completion method.
(1) In general.
(2) Computations.
(3) Post-completion-year income.
(4) Total contract price.
(i) In general.
(A) Definition.
(B) Contingent compensation.
(C) Non-long-term contract activities.
(ii) Estimating total contract price.

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*

*

*

*

(k) Mid-contract change in taxpayer
[Reserved]
§ 1.460–5 Cost allocation rules.
(a) Overview.
(b) Cost allocation method for contracts
subject to PCM.
(1) In general.
(2) Special rules.
(i) Direct material costs.
(ii) Components and subassemblies.
(iii) Simplified production methods.
(iv) Costs identified under cost-plus longterm contracts and federal long-term
contracts.
(v) Interest.
(A) In general.
(B) Production period.
(C) Application of section 263A(f).
(vi) Research and experimental expenses.
(vii) Service costs.
(A) Simplified service cost method.
(1) In general.
(2) Example.
(B) Jobsite costs.
(C) Limitation on other reasonable cost
allocation methods.
(c) Simplified cost-to-cost method for
contracts subject to the PCM.
(1) In general.
(2) Election.
(d) Cost allocation rules for exempt
construction contracts reported using
CCM.
(1) In general.
(2) Indirect costs.
(i) Indirect costs allocable to exempt
construction contracts.

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Federal Register / Vol. 66, No. 8 / Thursday, January 11, 2001 / Rules and Regulations
(ii) Indirect costs not allocable to exempt
construction contracts.
(3) Large homebuilders.
(e) Cost allocation rules for contracts subject
to the PCCM.
(f) Special rules applicable to costs allocated
under this section.
(1) Nondeductible costs.
(2) Costs incurred for non-long-term contract
activities.
(g) Method of accounting.
§ 1.460–6

*

*

Look-back method.

*

*

*

(f) * * *
(3) Statutes of limitations and compounding
of interest on look-back interest.

*

*
*
*
*
Par. 6. Sections 1.460–1 through
1.460–3 are revised to read as follows:
§ 1.460–1

Long-term contracts.

(a) Overview—(1) In general. This
section provides rules for determining
whether a contract for the manufacture,
building, installation, or construction of
property is a long-term contract under
section 460 and what activities must be
accounted for as a single long-term
contract. Specific rules for long-term
manufacturing and construction
contracts are provided in §§ 1.460–2 and
1.460–3, respectively. A taxpayer
generally must determine the income
from a long-term contract using the
percentage-of-completion method
described in § 1.460–4(b) (PCM) and the
cost allocation rules described in
§ 1.460–5(b) or (c). In addition, after a
contract subject to the PCM is
completed, a taxpayer generally must
apply the look-back method described
in § 1.460-6 to determine the amount of
interest owed on any hypothetical
underpayment of tax, or earned on any
hypothetical overpayment of tax,
attributable to accounting for the longterm contract under the PCM.
(2) Exceptions to required use of
PCM—(i) Exempt construction contract.
The requirement to use the PCM does
not apply to any exempt construction
contract described in § 1.460–3(b). Thus,
a taxpayer may determine the income
from an exempt construction contract
using any accounting method permitted
by § 1.460–4(c) and, for contracts
accounted for using the completedcontract method (CCM), any cost
allocation method permitted by § 1.460–
5(d). Exempt construction contracts that
are not subject to the PCM or CCM are
not subject to the cost allocation rules
of § 1.460–5 except for the productionperiod interest rules of § 1.460–
5(b)(2)(v). Exempt construction
contractors that are large homebuilders
described in § 1.460–5(d)(3) must
capitalize costs under section 263A. All
other exempt construction contractors

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must account for the cost of
construction using the appropriate rules
contained in other sections of the
Internal Revenue Code or regulations.
(ii) Qualified ship or residential
construction contract. The requirement
to use the PCM applies only to a portion
of a qualified ship contract described in
§ 1.460–2(d) or residential construction
contract described in § 1.460–3(c). A
taxpayer generally may determine the
income from a qualified ship contract or
residential construction contract using
the percentage-of-completion/
capitalized-cost method (PCCM)
described in § 1.460–4(e), but must use
a cost allocation method described in
§ 1.460–5(b) for the entire contract.
(b) Terms—(1) Long-term contract. A
long-term contract generally is any
contract for the manufacture, building,
installation, or construction of property
if the contract is not completed within
the contracting year, as defined in
paragraph (b)(5) of this section.
However, a contract for the manufacture
of property is a long-term contract only
if it also satisfies either the unique item
or 12-month requirements described in
§ 1.460–2. A contract for the
manufacture of personal property is a
manufacturing contract. In contrast, a
contract for the building, installation, or
construction of real property is a
construction contract.
(2) Contract for the manufacture,
building, installation, or construction of
property—(i) In general. A contract is a
contract for the manufacture, building,
installation, or construction of property
if the manufacture, building,
installation, or construction of property
is necessary for the taxpayer’s
contractual obligations to be fulfilled
and if the manufacture, building,
installation, or construction of that
property has not been completed when
the parties enter into the contract. If a
taxpayer has to manufacture or
construct an item to fulfill its
obligations under the contract, the fact
that the taxpayer is not required to
deliver that item to the customer is not
relevant. Whether the customer has title
to, control over, or bears the risk of loss
from, the property manufactured or
constructed by the taxpayer also is not
relevant. Furthermore, how the parties
characterize their agreement (e.g., as a
contract for the sale of property) is not
relevant.
(ii) De minimis construction activities.
Notwithstanding paragraph (b)(2)(i) of
this section, a contract is not a
construction contract under section 460
if the contract includes the provision of
land by the taxpayer and the estimated
total allocable contract costs, as defined
in paragraph (b)(3) of this section,

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attributable to the taxpayer’s
construction activities are less than 10
percent of the contract’s total contract
price, as defined in § 1.460–4(b)(4)(i).
For the purposes of this paragraph
(b)(2)(ii), the allocable contract costs
attributable to the taxpayer’s
construction activities do not include
the cost of the land provided to the
customer. In addition, a contract’s
estimated total allocable contract costs
include a proportionate share of the
estimated cost of any common
improvement that benefits the subject
matter of the contract if the taxpayer is
contractually obligated, or required by
law, to construct the common
improvement.
(3) Allocable contract costs. Allocable
contract costs are costs that are allocable
to a long-term contract under § 1.460–5.
(4) Related party. A related party is a
person whose relationship to a taxpayer
is described in section 707(b) or 267(b),
determined without regard to section
267(f)(1)(A) and determined by
replacing ‘‘at least 80 percent’’ with
‘‘more than 50 percent’’ for the purposes
of determining the ownership of the
stock of a corporation in sections
267(b)(2), (8), (10)(A), and (12).
(5) Contracting year. The contracting
year is the taxable year in which a
taxpayer enters into a contract as
described in paragraph (c)(2) of this
section.
(6) Completion year. The completion
year is the taxable year in which a
taxpayer completes a contract as
described in paragraph (c)(3) of this
section.
(7) Contract commencement date. The
contract commencement date is the date
that a taxpayer or related party first
incurs any allocable contract costs, such
as design and engineering costs, other
than expenses attributable to bidding
and negotiating activities. Generally, the
contract commencement date is relevant
in applying § 1.460–6(b)(3) (concerning
the de minimis exception to the lookback method under section
460(b)(3)(B)); § 1.460–5(b)(2)(v)(B)(1)(i)
(concerning the production period
subject to interest allocation); § 1.460–
2(d) (concerning qualified ship
contracts); and § 1.460–3(b)(1)(ii)
(concerning the construction period for
exempt construction contracts).
(8) Incurred. Incurred has the
meaning given in § 1.461–1(a)(2)
(concerning the taxable year a liability
is incurred under the accrual method of
accounting), regardless of a taxpayer’s
overall method of accounting. See
§ 1.461–4(d)(2)(ii) for economic
performance rules concerning the PCM.
(9) Independent research and
development expenses. Independent

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research and development expenses are
any expenses incurred in the
performance of research or
development, except that this term does
not include any expenses that are
directly attributable to a particular longterm contract in existence when the
expenses are incurred and this term
does not include any expenses under an
agreement to perform research or
development.
(10) Long-term contract methods of
accounting. Long-term contract methods
of accounting, which include the PCM,
the CCM, the PCCM, and the exemptcontract percentage-of-completion
method (EPCM), are methods of
accounting that may be used only for
long-term contracts.
(c) Entering into and completing longterm contracts—(1) In general. To
determine when a contract is entered
into under paragraph (c)(2) of this
section and completed under paragraph
(c)(3) of this section, a taxpayer must
consider all relevant allocable contract
costs incurred and activities performed
by itself, by related parties on its behalf,
and by the customer, that are incident
to or necessary for the long-term
contract. In addition, to determine
whether a contract is completed in the
contracting year, the taxpayer may not
consider when it expects to complete
the contract.
(2) Date contract entered into—(i) In
general. A taxpayer enters into a
contract on the date that the contract
binds both the taxpayer and the
customer under applicable law, even if
the contract is subject to unsatisfied
conditions not within the taxpayer’s
control (such as obtaining financing). If
a taxpayer delays entering into a
contract for a principal purpose of
avoiding section 460, however, the
taxpayer will be treated as having
entered into a contract not later than the
contract commencement date.
(ii) Options and change orders. A
taxpayer enters into a new contract on
the date that the customer exercises an
option or similar provision in a contract
if that option or similar provision must
be severed from the contract under
paragraph (e) of this section. Similarly,
a taxpayer enters into a new contract on
the date that it accepts a change order
or other similar agreement if the change
order or other similar agreement must
be severed from the contract under
paragraph (e) of this section.
(3) Date contract completed—(i) In
general. A taxpayer’s contract is
completed upon the earlier of—
(A) Use of the subject matter of the
contract by the customer for its intended
purpose (other than for testing) and at
least 95 percent of the total allocable

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contract costs attributable to the subject
matter have been incurred by the
taxpayer; or
(B) Final completion and acceptance
of the subject matter of the contract.
(ii) Secondary items. The date a
contract accounted for using the CCM is
completed is determined without regard
to whether one or more secondary items
have been used or finally completed and
accepted. If any secondary items are
incomplete at the end of the taxable year
in which the primary subject matter of
a contract is completed, the taxpayer
must separate the portion of the gross
contract price and the allocable contract
costs attributable to the incomplete
secondary item(s) from the completed
contract and account for them using a
permissible method of accounting. A
permissible method of accounting
includes a long-term contract method of
accounting only if a separate contract
for the secondary item(s) would be a
long-term contract, as defined in
paragraph (b)(1) of this section.
(iii) Subcontracts. In the case of a
subcontract, a subcontractor’s customer
is the general contractor. Thus, the
subject matter of the subcontract is the
relevant subject matter under paragraph
(c)(3)(i) of this section.
(iv) Final completion and
acceptance—(A) In general. Except as
otherwise provided in this paragraph
(c)(3)(iv), to determine whether final
completion and acceptance of the
subject matter of a contract have
occurred, a taxpayer must consider all
relevant facts and circumstances.
Nevertheless, a taxpayer may not delay
the completion of a contract for the
principal purpose of deferring federal
income tax.
(B) Contingent compensation. Final
completion and acceptance is
determined without regard to any
contractual term that provides for
additional compensation that is
contingent on the successful
performance of the subject matter of the
contract. A taxpayer must account for
all contingent compensation that is not
includible in total contract price under
§ 1.460–4(b)(4)(i), or in gross contract
price under § 1.460–4(d)(3), using a
permissible method of accounting. For
application of the look-back method for
contracts accounted for using the PCM,
see § 1.460–6(c)(1)(ii) and (2)(vi).
(C) Assembly or installation. Final
completion and acceptance is
determined without regard to whether
the taxpayer has an obligation to assist
or supervise assembly or installation of
the subject matter of the contract where
the assembly or installation is not
performed by the taxpayer or a related
party. A taxpayer must account for the

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gross receipts and costs attributable to
such an obligation using a permissible
method of accounting, other than a longterm contract method.
(D) Disputes. Final completion and
acceptance is determined without
regard to whether a dispute exists at the
time the taxpayer tenders the subject
matter of the contract to the customer.
For contracts accounted for using the
CCM, see § 1.460–4(d)(4). For
application of the look-back method for
contracts accounted for using the PCM,
see § 1.460–6(c)(1)(ii) and (2)(vi).
(d) Allocation among activities—(1) In
general. Long-term contract methods of
accounting apply only to the gross
receipts and costs attributable to longterm contract activities. Gross receipts
and costs attributable to long-term
contract activities means amounts
included in total contract price or gross
contract price, whichever is applicable,
as determined under § 1.460–4, and
costs allocable to the contract, as
determined under § 1.460–5. Gross
receipts and costs attributable to nonlong-term contract activities (as defined
in paragraph (d)(2) of this section)
generally must be taken into account
using a permissible method of
accounting other than a long-term
contract method. See section 446(c) and
§ 1.446–1(c). However, if the
performance of a non-long-term contract
activity is incident to or necessary for
the manufacture, building, installation,
or construction of the subject matter of
one or more of the taxpayer’s long-term
contracts, the gross receipts and costs
attributable to that activity must be
allocated to the long-term contract(s)
benefitted as provided in §§ 1.460–
4(b)(4)(i) and 1.460–5(f)(2), respectively.
Similarly, if a single long-term contract
requires a taxpayer to perform a nonlong-term contract activity that is not
incident to or necessary for the
manufacture, building, installation, or
construction of the subject matter of the
long-term contract, the gross receipts
and costs attributable to that non-longterm contract activity must be separated
from the contract and accounted for
using a permissible method of
accounting other than a long-term
contract method. But see paragraph (g)
of this section for related party rules.
(2) Non-long-term contract activity.
Non-long-term contract activity means
the performance of an activity other
than manufacturing, building,
installation, or construction, such as the
provision of architectural, design,
engineering, and construction
management services, and the
development or implementation of
computer software. In addition,
performance under a guaranty,

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warranty, or maintenance agreement is
a non-long-term contract activity that is
never incident to or necessary for the
manufacture or construction of property
under a long-term contract.
(e) Severing and aggregating
contracts—(1) In general. After
application of the allocation rules of
paragraph (d) of this section, the
severing and aggregating rules of this
paragraph (e) may be applied by the
Commissioner or the taxpayer as
necessary to clearly reflect income (e.g.,
to prevent the unreasonable deferral (or
acceleration) of income or the premature
recognition (or deferral) of loss). Under
the severing and aggregating rules, one
agreement may be treated as two or
more contracts, and two or more
agreements may be treated as one
contract. Except as provided in
paragraph (e)(3)(ii) of this section, a
taxpayer must determine whether to
sever an agreement or to aggregate two
or more agreements based on the facts
and circumstances known at the end of
the contracting year.
(2) Facts and circumstances. Whether
an agreement should be severed, or two
or more agreements should be
aggregated, depends on the following
factors:
(i) Pricing. Independent pricing of
items in an agreement is necessary for
the agreement to be severed into two or
more contracts. In the case of an
agreement for similar items, if the price
to be paid for the items is determined
under different terms or formulas (e.g.,
if some items are priced under a costplus incentive fee arrangement and later
items are to be priced under a fixedprice arrangement), then the difference
in the pricing terms or formulas
indicates that the items are
independently priced. Similarly,
interdependent pricing of items in
separate agreements is necessary for two
or more agreements to be aggregated
into one contract. A single price
negotiation for similar items ordered
under one or more agreements indicates
that the items are interdependently
priced.
(ii) Separate delivery or acceptance.
An agreement may not be severed into
two or more contracts unless it provides
for separate delivery or separate
acceptance of items that are the subject
matter of the agreement. However, the
separate delivery or separate acceptance
of items by itself does not necessarily
require an agreement to be severed.
(iii) Reasonable businessperson. Two
or more agreements to perform
manufacturing or construction activities
may not be aggregated into one contract
unless a reasonable businessperson
would not have entered into one of the

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agreements for the terms agreed upon
without also entering into the other
agreement(s). Similarly, an agreement to
perform manufacturing or construction
activities may not be severed into two
or more contracts if a reasonable
businessperson would not have entered
into separate agreements containing
terms allocable to each severed contract.
Analyzing the reasonable
businessperson standard requires an
analysis of all the facts and
circumstances of the business
arrangement between the taxpayer and
the customer. For purposes of this
paragraph (e)(2)(iii), a taxpayer’s
expectation that the parties would enter
into another agreement, when agreeing
to the terms contained in the first
agreement, is not relevant.
(3) Exceptions—(i) Severance for
PCM. A taxpayer may not sever under
this paragraph (e) a long-term contract
that would be subject to the PCM
without obtaining the Commissioner’s
prior written consent.
(ii) Options and change orders.
Except as provided in paragraph (e)(3)(i)
of this section, a taxpayer must sever an
agreement that increases the number of
units to be supplied to the customer,
such as through the exercise of an
option or the acceptance of a change
order, if the agreement provides for
separate delivery or separate acceptance
of the additional units.
(4) Statement with return. If a
taxpayer severs an agreement or
aggregates two or more agreements
under this paragraph (e) during the
taxable year, the taxpayer must attach a
statement to its original federal income
tax return for that year. This statement
must contain the following
information—
(i) The legend NOTIFICATION OF
SEVERANCE OR AGGREGATION
UNDER SEC. 1.460–1(e);
(ii) The taxpayer’s name; and
(iii) The taxpayer’s employer
identification number or social security
number.
(f) Classifying contracts—(1) In
general. After applying the severing and
aggregating rules of paragraph (e) of this
section, a taxpayer must determine the
classification of a contract (e.g., as a
long-term manufacturing contract, longterm construction contract, non-longterm contract) based on all the facts and
circumstances known no later than the
end of the contracting year.
Classification is determined on a
contract-by-contract basis.
Consequently, a requirement to
manufacture a single unique item under
a long-term contract will subject all
other items in that contract to section
460.

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(2) Hybrid contracts—(i) In general. A
long-term contract that requires a
taxpayer to perform both manufacturing
and construction activities (hybrid
contract) generally must be classified as
two contracts, a manufacturing contract
and a construction contract. A taxpayer
may elect, on a contract-by-contract
basis, to classify a hybrid contract as a
long-term construction contract if at
least 95 percent of the estimated total
allocable contract costs are reasonably
allocable to construction activities. In
addition, a taxpayer may elect, on a
contract-by-contract basis, to classify a
hybrid contract as a long-term
manufacturing contract subject to the
PCM.
(ii) Elections. A taxpayer makes an
election under this paragraph (f)(2) by
using its method of accounting for
similar construction contracts or for
manufacturing contracts, whichever is
applicable, to account for a hybrid
contract entered into during the taxable
year of the election on its original
federal income tax return for the
election year. If an electing taxpayer’s
method is the PCM, the taxpayer also
must use the PCM to apply the lookback method under § 1.460–6 and to
determine alternative minimum taxable
income under § 1.460–4(f).
(3) Method of accounting. Except as
provided in paragraph (f)(2)(ii) of this
section, a taxpayer’s method of
classifying contracts is a method of
accounting under section 446 and, thus,
may not be changed without the
Commissioner’s consent. If a taxpayer’s
method of classifying contracts is
unreasonable, that classification method
is an impermissible accounting method.
(4) Use of estimates—(i) Estimating
length of contract. A taxpayer must use
a reasonable estimate of the time
required to complete a contract when
necessary to classify the contract (e.g., to
determine whether the five-year
completion rule for qualified ship
contracts under § 1.460–2(d), or the twoyear completion rule for exempt
construction contracts under § 1.460–
3(b), is satisfied, but not to determine
whether a contract is completed within
the contracting year under paragraph
(b)(1) of this section). To be considered
reasonable, an estimate of the time
required to complete the contract must
include anticipated time for delay,
rework, change orders, technology or
design problems, or other problems that
reasonably can be anticipated
considering the nature of the contract
and prior experience. A contract term
that specifies an expected completion or
delivery date may be considered
evidence that the taxpayer reasonably
expects to complete or deliver the

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subject matter of the contract on or
about the date specified, especially if
the contract provides bona fide
penalties for failing to meet the
specified date. If a taxpayer classifies a
contract based on a reasonable estimate
of completion time, the contract will not
be reclassified based on the actual (or
another reasonable estimate of)
completion time. A taxpayer’s estimate
of completion time will not be
considered unreasonable if a contract is
not completed within the estimated
time primarily because of unforeseeable
factors not within the taxpayer’s control,
such as third-party litigation, extreme
weather conditions, strikes, or delays in
securing permits or licenses.
(ii) Estimating allocable contract
costs. A taxpayer must use a reasonable
estimate of total allocable contract costs
when necessary to classify the contract
(e.g., to determine whether a contract is
a home construction contract under
§ 1.460–(3)(b)(2)). If a taxpayer classifies
a contract based on a reasonable
estimate of total allocable contract costs,
the contract will not be reclassified
based on the actual (or another
reasonable estimate of) total allocable
contract costs.
(g) Special rules for activities
benefitting long-term contracts of a
related party—(1) Related party use of
PCM—(i) In general. Except as provided
in paragraph (g)(1)(ii) of this section, if
a related party and its customer enter
into a long-term contract subject to the
PCM, and a taxpayer performs any
activity that is incident to or necessary
for the related party’s long-term
contract, the taxpayer must account for
the gross receipts and costs attributable
to this activity using the PCM, even if
this activity is not otherwise subject to
section 460(a). This type of activity may
include, for example, the performance
of engineering and design services, and
the production of components and
subassemblies that are reasonably
expected to be used in the production
of the subject matter of the related
party’s contract.
(ii) Exception for components and
subassemblies. A taxpayer is not
required to use the PCM under this
paragraph (g) to account for a
component or subassembly that benefits
a related party’s long-term contract if
more than 50 percent of the average
annual gross receipts attributable to the
sale of this item for the 3-taxable-yearperiod ending with the contracting year
comes from unrelated parties.
(2) Total contract price. If a taxpayer
is required to use the PCM under
paragraph (g)(1)(i) of this section, the
total contract price (as defined in
§ 1.460–4(b)(4)(i)) is the fair market

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value of the taxpayer’s activity that is
incident to or necessary for the
performance of the related party’s longterm contract. The related party also
must use the fair market value of the
taxpayer’s activity as the cost it incurs
for the activity. The fair market value of
the taxpayer’s activity may or may not
be the same as the amount the related
party pays the taxpayer for that activity.
(3) Completion factor. To compute a
contract’s completion factor (as
described in § 1.460–4(b)(5)), the related
party must take into account the fair
market value of the taxpayer’s activity
that is incident to or necessary for the
performance of the related party’s longterm contract when the related party
incurs the liability to the taxpayer for
the activity, rather than when the
taxpayer incurs the costs to perform the
activity.
(h) Effective date—(1) In general.
Except as otherwise provided, this
section and §§ 1.460–2 through 1.460–5
are applicable for contracts entered into
on or after January 11, 2001.
(2) Change in method of accounting.
Any change in a taxpayer’s method of
accounting necessary to comply with
this section and §§ 1.460–2 through
1.460–5 is a change in method of
accounting to which the provisions of
section 446 and the regulations
thereunder apply. For the first taxable
year that includes January 11, 2001, a
taxpayer is granted the consent of the
Commissioner to change its method of
accounting to comply with the
provisions of this section and §§ 1.460–
2 through 1.460–5 for long-term
contracts entered into on or after
January 11, 2001. A taxpayer that wants
to change its method of accounting
under this paragraph (h)(2) must follow
the automatic consent procedures in
Rev. Proc. 99–49 (1999–52 I.R.B. 725)
(see § 601.601(d)(2) of this chapter),
except that the scope limitations in
section 4.02 of Rev. Proc. 99–49 do not
apply. Because a change under this
paragraph (h)(2) is made on a cut-off
basis, a section 481(a) adjustment is not
permitted or required. Moreover, the
taxpayer does not receive audit
protection under section 7 of Rev. Proc.
99–49 for a change in method of
accounting under this paragraph (h)(2).
A taxpayer that wants to change its
exempt-contract method of accounting
is not granted the consent of the
Commissioner under this paragraph
(h)(2) and must file a Form 3115,
‘‘Application for Change in Accounting
Method,’’ to obtain consent. See Rev.
Proc. 97–27 (1997–1 C.B. 680) (see
§ 601.601(d)(2) of this chapter).
(i) [Reserved]

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(j) Examples. The following examples
illustrate the rules of this section:
Example 1. Contract for manufacture of
property. B notifies C, an aircraft
manufacturer, that it wants to purchase an
aircraft of a particular type. At the time C
receives the order, C has on hand several
partially completed aircraft of this type;
however, C does not have any completed
aircraft of this type on hand. C and B agree
that B will purchase one of these aircraft after
it has been completed. C retains title to and
risk of loss with respect to the aircraft until
the sale takes place. The agreement between
C and B is a contract for the manufacture of
property under paragraph (b)(2)(i) of this
section, even if labeled as a contract for the
sale of property, because the manufacture of
the aircraft is necessary for C’s obligations
under the agreement to be fulfilled and the
manufacturing was not complete when B and
C entered into the agreement.
Example 2. De minimis construction
activity. C, a master developer whose taxable
year ends December 31, owns 5,000 acres of
undeveloped land with a cost basis of
$5,000,000 and a fair market value of
$50,000,000. To obtain permission from the
local county government to improve this
land, a service road must be constructed on
this land to benefit all 5,000 acres. In 2001,
C enters into a contract to sell a 1,000-acre
parcel of undeveloped land to B, a residential
developer, for its fair market value,
$10,000,000. In this contract, C agrees to
construct a service road running through the
land that C is selling to B and through the
4,000 adjacent acres of undeveloped land
that C has sold or will sell to other residential
developers for its fair market value,
$40,000,000. C reasonably estimates that it
will incur allocable contract costs of $50,000
(excluding the cost of the land) to construct
this service road, which will be owned and
maintained by the county. C must reasonably
allocate the cost of the service road among
the benefitted parcels. The portion of the
estimated total allocable contract costs that C
allocates to the 1,000-acre parcel being sold
to B (based upon its fair market value) is
$10,000 ($50,000 x ($10,000,000
$50,000,000)). Construction of the service
road is finished in 2002. Because the
estimated total allocable contract costs
attributable to C’s construction activities,
$10,000, are less than 10 percent of the
contract’s total contract price, $10,000,000,
C’s contract with B is not a construction
contract under paragraph (b)(2)(ii) of this
section. Thus, C’s contract with B is not a
long-term contract under paragraph (b)(2)(i)
of this section, notwithstanding that
construction of the service road is not
completed in 2001.
Example 3. Completion—customer use. In
2002, C, whose taxable year ends December
31, enters into a contract to construct a
building for B. In November of 2003, the
building is completed in every respect
necessary for its intended use, and B
occupies the building. In early December of
2003, B notifies C of some minor deficiencies
that need to be corrected, and C agrees to
correct them in January 2004. C reasonably
estimates that the cost of correcting these
deficiencies will be less than five percent of

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the total allocable contract costs. C’s contract
is complete under paragraph (c)(3)(i)(A) of
this section in 2003 because in that year, B
used the building and C had incurred at least
95 percent of the total allocable contract costs
attributable to the building. C must use a
permissible method of accounting for any
deficiency-related costs incurred after 2003.
Example 4. Completion—customer use. In
2001, C, whose taxable year ends December
31, agrees to construct a shopping center,
which includes an adjoining parking lot, for
B. By October 2002, C has finished
constructing the retail portion of the
shopping center. By December 2002, C has
graded the entire parking lot, but has paved
only one-fourth of it because inclement
weather conditions prevented C from laying
asphalt on the remaining three-fourths. In
December 2002, B opens the retail portion of
the shopping center and the paved portion of
the parking lot to the general public. C
reasonably estimates that the cost of paving
the remaining three-fourths of the parking lot
when weather permits will exceed five
percent of C’s total allocable contract costs.
Even though B is using the subject matter of
the contract, C’s contract is not completed in
December 2002 under paragraph (c)(3)(i)(A)
of this section because C has not incurred at
least 95 percent of the total allocable contract
costs attributable to the subject matter.
Example 5. Completion—customer use. In
2001, C, whose taxable year ends December
31, agrees to manufacture 100 machines for
B. By December 31, 2002, C has delivered 99
of the machines to B. C reasonably estimates
that the cost of finishing the related work on
the contract will be less than five percent of
the total allocable contract costs. C’s contract
is not complete under paragraph (c)(3)(i)(A)
of this section in 2002 because in that year,
B is not using the subject matter of the
contract (all 100 machines) for its intended
purpose.
Example 6. Non-long-term contract
activity. On January 1, 2001, C, whose taxable
year ends December 31, enters into a single
long-term contract to design and manufacture
a satellite and to develop computer software
enabling B to operate the satellite. At the end
of 2001, C has not finished manufacturing the
satellite. Designing the satellite and
developing the computer software are nonlong-term contract activities that are incident
to and necessary for the taxpayer’s
manufacturing of the subject matter of a longterm contract because the satellite could not
be manufactured without the design and
would not operate without the software.
Thus, under paragraph (d)(1) of this section,
C must allocate these non-long-term contract
activities to the long-term contract and
account for the gross receipts and costs
attributable to designing the satellite and
developing computer software using the
PCM.
Example 7. Non-long-term contract
activity. C agrees to manufacture equipment
for B under a long-term contract. In a
separate contract, C agrees to design the
equipment being manufactured for B under
the long-term contract. Under paragraph
(d)(1) of this section, C must allocate the
gross receipts and costs related to the design
to the long-term contract because designing

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the equipment is a non-long-term contract
activity that is incident to and necessary for
the manufacture of the subject matter of the
long-term contract.
Example 8. Severance. On January 1, 2001,
C, a construction contractor, and B, a real
estate investor, enter into an agreement
requiring C to build two office buildings in
different areas of a large city. The agreement
provides that the two office buildings will be
completed by C and accepted by B in 2002
and 2003, respectively, and that C will be
paid $1,000,000 and $1,500,000 for the two
office buildings, respectively. The agreement
will provide C with a reasonable profit from
the construction of each building. Unless C
is required to use the PCM to account for the
contract, C is required to sever this contract
under paragraph (e)(2) of this section because
the buildings are independently priced, the
agreement provides for separate delivery and
acceptance of the buildings, and, as each
building will generate a reasonable profit, a
reasonable businessperson would have
entered into separate agreements for the
terms agreed upon for each building.
Example 9. Severance. C, a large
construction contractor whose taxable year
ends December 31, accounts for its
construction contracts using the PCM and
has elected to use the 10-percent method
described in § 1.460–4(b)(6). In September
2001, C enters into an agreement to construct
four buildings in four different cities. The
buildings are independently priced and the
contract provides a reasonable profit for each
of the buildings. In addition, the agreement
requires C to complete one building per year
in 2002, 2003, 2004, and 2005. As of
December 31, 2001, C has incurred 25
percent of the estimated total allocable
contract costs attributable to one of the
buildings, but only five percent of the
estimated total allocable contract costs
attributable to all four buildings included in
the agreement. C does not request the
Commissioner’s consent to sever this
contract. Using the 10-percent method, C
does not take into account any portion of the
total contract price or any incurred allocable
contract costs attributable to this agreement
in 2001. Upon examination of C’s 2001 tax
return, the Commissioner determines that C
entered into one agreement for four buildings
rather than four separate agreements each for
one building solely to take advantage of the
deferral obtained under the 10-percent
method. Consequently, to clearly reflect the
taxpayer’s income, the Commissioner may
require C to sever the agreement into four
separate contracts under paragraph (e)(2) of
this section because the buildings are
independently priced, the agreement
provides for separate delivery and acceptance
of the buildings, and a reasonable
businessperson would have entered into
separate agreements for these buildings.
Example 10. Aggregation. In 2001, C, a
shipbuilder, enters into two agreements with
the Department of the Navy as the result of
a single negotiation. Each agreement
obligates C to manufacture a submarine.
Because the submarines are of the same class,
their specifications are similar. Because C has
never manufactured submarines of this class,
however, C anticipates that it will incur

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substantially higher costs to manufacture the
first submarine, to be delivered in 2007, than
to manufacture the second submarine, to be
delivered in 2010. If the agreements are
treated as separate contracts, the first contract
probably will produce a substantial loss,
while the second contract probably will
produce substantial profit. Based upon these
facts, aggregation is required under paragraph
(e)(2) of this section because the submarines
are interdependently priced and a reasonable
businessperson would not have entered the
first agreement without also entering into the
second.
Example 11. Aggregation. In 2001, C, a
manufacturer of aircraft and related
equipment, agrees to manufacture 10 military
aircraft for foreign government B and to
deliver the aircraft by the end of 2003. When
entering into the agreement, C anticipates
that it might receive production orders from
B over the next 20 years for as many as 300
more of these aircraft. The negotiated
contract price reflects C’s and B’s
consideration of the expected total cost of
manufacturing the 10 aircraft, the risks and
opportunities associated with the agreement,
and the additional factors the parties
considered relevant. The negotiated price
provides a profit on the sale of the 10 aircraft
even if C does not receive any additional
production orders from B. It is unlikely,
however, that C actually would have wanted
to manufacture the 10 aircraft but for the
expectation that it would receive additional
production orders from B. In 2003, B accepts
delivery of the 10 aircraft. At that time, B
orders an additional 20 aircraft of the same
type for delivery in 2007. When negotiating
the price for the additional 20 aircraft, C and
B consider the fact that the expected unit cost
for this production run of 20 aircraft will be
lower than the unit cost of the 10 aircraft
completed and accepted in 2003, but
substantially higher than the expected unit
cost of future production runs. Based upon
these facts, aggregation is not permitted
under paragraph (e)(2) of this section.
Because the parties negotiated the prices of
both agreements considering only the
expected production costs and risks for each
agreement standing alone, the terms and
conditions agreed upon for the first
agreement are independent of the terms and
conditions agreed upon for the second
agreement. The fact that the agreement to
manufacture 10 aircraft provides a profit for
C indicates that a reasonable businessperson
would have entered into that agreement
without entering into the agreement to
manufacture the additional 20 aircraft.
Example 12. Classification and
completion. In 2001, C, whose taxable year
ends December 31, agrees to manufacture and
install an industrial machine for B. C elects
under paragraph (f) of this section to classify
the agreement as a long-term manufacturing
contract and to account for it using the PCM.
The agreement requires C to deliver the
machine in August 2003 and to install and
test the machine in B’s factory. In addition,
the agreement requires B to accept the
machine when the tests prove that the
machine’s performance will satisfy the
environmental standards set by the
Environmental Protection Agency (EPA),

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even if B has not obtained the required
operating permit. Because of technical
difficulties, C cannot deliver the machine
until December 2003, when B conditionally
accepts delivery. C installs the machine in
December 2003 and then tests it through
February 2004. B accepts the machine in
February 2004, but does not obtain the
operating permit from the EPA until January
2005. Under paragraph (c)(3)(i)(B) of this
section, C’s contract is finally completed and
accepted in February 2004, even though B
does not obtain the operating permit until
January 2005, because C completed all its
obligations under the contract and B
accepted the machine in February 2004.
§ 1.460–2 Long-term manufacturing
contracts.

(a) In general. Section 460 generally
requires a taxpayer to determine the
income from a long-term manufacturing
contract using the percentage-ofcompletion method described in
§ 1.460–4(b) (PCM). A contract not
completed in the contracting year is a
long-term manufacturing contract if it
involves the manufacture of personal
property that is—
(1) A unique item of a type that is not
normally carried in the finished goods
inventory of the taxpayer; or
(2) An item that normally requires
more than 12 calendar months to
complete (regardless of the duration of
the contract or the time to complete a
deliverable quantity of the item).
(b) Unique—(1) In general. Unique
means designed for the needs of a
specific customer. To determine
whether an item is designed for the
needs of a specific customer, a taxpayer
must consider the extent to which
research, development, design,
engineering, retooling, and similar
activities (customizing activities) are
required to manufacture the item and
whether the item could be sold to other
customers with little or no modification.
A contract may require the taxpayer to
manufacture more than one unit of a
unique item. If a contract requires a
taxpayer to manufacture more than one
unit of the same item, the taxpayer must
determine whether that item is unique
by considering the customizing
activities that would be needed to
produce only the first unit. For the
purposes of this paragraph (b), a
taxpayer must consider the activities
performed on its behalf by a
subcontractor.
(2) Safe harbors. Notwithstanding
paragraph (b)(1) of this section, an item
is not unique if it satisfies one or more
of the safe harbors in this paragraph
(b)(2). If an item does not satisfy one or
more safe harbors, the determination of
uniqueness will depend on the facts and
circumstances. The safe harbors are:

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(i) Short production period. An item
is not unique if it normally requires 90
days or less to complete. In the case of
a contract for multiple units of an item,
the item is not unique only if it
normally requires 90 days or less to
complete each unit of the item in the
contract.
(ii) Customized item. An item is not
unique if the total allocable contract
costs attributable to customizing
activities that are incident to or
necessary for the manufacture of the
item do not exceed 10 percent of the
estimated total allocable contract costs
allocable to the item. In the case of a
contract for multiple units of an item,
this comparison must be performed on
the first unit of the item and the total
allocable contract costs attributable to
customizing activities that are incident
to or necessary for the manufacture of
the item must be allocated to the first
unit.
(iii) Inventoried item. A unique item
ceases to be unique no later than when
the taxpayer normally includes similar
items in its finished goods inventory.
(c) Normal time to complete—(1) In
general. The amount of time normally
required to complete an item is the
item’s reasonably expected production
period, as described in § 1.263A–12,
determined at the end of the contracting
year. Thus, in general, the expected
production period for an item begins
when a taxpayer incurs at least five
percent of the costs that would be
allocable to the item under § 1.460–5
and ends when the item is ready to be
held for sale and all reasonably
expected production activities are
complete. In the case of components
that are assembled or reassembled into
an item or unit at the customer’s facility
by the taxpayer’s employees or agents,
the production period ends when the
components are assembled or
reassembled into an operable item or
unit. To the extent that several distinct
activities related to the production of
the item are expected to occur
simultaneously, the period during
which these distinct activities occur is
not counted more than once.
Furthermore, when determining the
normal time to complete an item, a
taxpayer is not required to consider
activities performed or costs incurred
that would not be allocable contract
costs under section 460 (e.g.,
independent research and development
expenses (as defined in § 1.460–1(b)(9))
and marketing expenses). Moreover, the
time required to design and
manufacture the first unit of an item for
which the taxpayer intends to produce
multiple units generally does not

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indicate the normal time to complete
the item.
(2) Production by related parties. To
determine the time normally required to
complete an item, a taxpayer must
consider all relevant production
activities performed and costs incurred
by itself and by related parties, as
defined in § 1.460–1(b)(4). For example,
if a taxpayer’s item requires a
component or subassembly
manufactured by a related party, the
taxpayer must consider the time the
related party takes to complete the
component or subassembly and, for
purposes of determining the beginning
of an item’s production period, the costs
incurred by the related party that are
allocable to the component or
subassembly. However, if both
requirements of the exception for
components and subassemblies under
§ 1.460–1(g)(1)(ii) are satisfied, a
taxpayer does not consider the activities
performed or the costs incurred by a
related party when determining the
normal time to complete an item.
(d) Qualified ship contracts. A
taxpayer may determine the income
from a long-term manufacturing contract
that is a qualified ship contract using
either the PCM or the percentage-ofcompletion/capitalized-cost method
(PCCM) of accounting described in
§ 1.460–4(e). A qualified ship contract is
any contract entered into after February
28, 1986, to manufacture in the United
States not more than 5 seagoing vessels
if the vessels will not be manufactured
directly or indirectly for the United
States Government and if the taxpayer
reasonably expects to complete the
contract within 5 years of the contract
commencement date. Under § 1.460–
1(e)(3)(i), a contract to produce more
than 5 vessels for which the PCM would
be required cannot be severed in order
to be classified as a qualified ship
contract.
(e) Examples. The following examples
illustrate the rules of this section:
Example 1. Unique item and classification.
In December 2001, C enters into a contract
with B to design and manufacture a new type
of industrial equipment. C reasonably
expects the normal production period for this
type of equipment to be eight months.
Because the new type of industrial
equipment requires a substantial amount of
research, design, and engineering to produce,
C determines that the equipment is a unique
item and its contract with B is a long-term
contract. After delivering the equipment to B
in September 2002, C contracts with B to
produce five additional units of that
industrial equipment with certain different
specifications. These additional units, which
also are expected to take eight months to
produce, will be delivered to B in 2003. C
determines that the research, design,

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engineering, retooling, and similar
customizing costs necessary to produce the
five additional units of equipment does not
exceed 10 percent of the first unit’s share of
estimated total allocable contract costs.
Consequently, the additional units of
equipment satisfy the safe harbor in
paragraph (b)(2)(ii) of this section and are not
unique items. Although C’s contract with B
to produce the five additional units is not
completed within the contracting year, the
contract is not a long-term contract since the
additional units of equipment are not unique
items and do not normally require more than
12 months to produce. C must classify its
second contract with B as a non-long term
contract, notwithstanding that it classified
the previous contract with B for a similar
item as a long-term contract, because the
determination of whether a contract is a longterm contract is made on a contract-bycontract basis. A change in classification is
not a change in method of accounting
because the change in classification results
from a change in underlying facts.
Example 2. 12-month rule—related party.
C manufactures cranes. C purchases one of
the crane’s components from R, a related
party under § 1.460–1(b)(4). Less than 50
percent of R’s gross receipts attributable to
the sale of this component comes from sales
to unrelated parties; thus, the exception for
components and subassemblies under
§ 1.460–1(g)(1)(ii) is not satisfied.
Consequently, C must consider the activities
of R as R incurs costs and performs the
activities rather than as C incurs a liability
to R. The normal time period between the
time that both C and R incur five percent of
the costs allocable to the crane and the time
that R completes the component is five
months. C normally requires an additional
eight months to complete production of the
crane after receiving the integral component
from R. C’s crane is an item of a type that
normally requires more than 12 months to
complete under paragraph (c) of this section
because the production period from the time
that both C and R incur five percent of the
costs allocable to the crane until the time that
production of the crane is complete is
normally 13 months.
Example 3. 12-month rule—duration of
contract. The facts are the same as in
Example 2, except that C enters into a sales
contract with B on December 31, 2001 (the
last day of C’s taxable year), and delivers a
completed crane to B on February 1, 2002.
C’s contract with B is a long-term contract
under paragraph (a)(2) of this section because
the contract is not completed in the
contracting year, 2001, and the crane is an
item that normally requires more than 12
calendar months to complete (regardless of
the duration of the contract).
Example 4. 12-month rule—normal time to
complete. The facts are the same as in
Example 2, except that C (and R) actually
complete B’s crane in only 10 calendar
months. The contract is a long-term contract
because the normal time to complete a crane,
not the actual time to complete a crane, is the
relevant criterion for determining whether an
item is subject to paragraph (a)(2) of this
section.
Example 5. Normal time to complete. C
enters into a multi-unit contract to produce

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four units of an item. C does not anticipate
producing any additional units of the item.
C expects to perform the research, design,
and development that are directly allocable
to the particular item and to produce the first
unit in the first 24 months. C reasonably
expects the production period for each of the
three remaining units will be 3 months. This
contract is not a contract that involves the
manufacture of an item that normally
requires more than 12 months to complete
because the normal time to complete the item
is 3 months. However, the contract does not
satisfy the 90-day safe harbor for unique
items because the normal time to complete
the first unit of this item exceeds 90 days.
Thus, the contract might involve the
manufacture of a unique item depending on
the facts and circumstances.
§ 1.460–3 Long-term construction
contracts.

(a) In general. Section 460 generally
requires a taxpayer to determine the
income from a long-term construction
contract using the percentage-ofcompletion method described in
§ 1.460–4(b) (PCM). A contract not
completed in the contracting year is a
long-term construction contract if it
involves the building, construction,
reconstruction, or rehabilitation of real
property; the installation of an integral
component to real property; or the
improvement of real property
(collectively referred to as construction).
Real property means land, buildings,
and inherently permanent structures, as
defined in § 1.263A–8(c)(3), such as
roadways, dams, and bridges. Real
property does not include vessels,
offshore drilling platforms, or unsevered
natural products of land. An integral
component to real property includes
property not produced at the site of the
real property but intended to be
permanently affixed to the real property,
such as elevators and central heating
and cooling systems. Thus, for example,
a contract to install an elevator in a
building is a construction contract
because a building is real property, but
a contract to install an elevator in a ship
is not a construction contract because a
ship is not real property.
(b) Exempt construction contracts—
(1) In general. The general requirement
to use the PCM and the cost allocation
rules described in § 1.460–5(b) or (c)
does not apply to any long-term
construction contract described in this
paragraph (b) (exempt construction
contract). Exempt construction contract
means any—
(i) Home construction contract; and
(ii) Other construction contract that a
taxpayer estimates (when entering into
the contract) will be completed within
2 years of the contract commencement
date, provided the taxpayer satisfies the

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$10,000,000 gross receipts test described
in paragraph (b)(3) of this section.
(2) Home construction contract—(i) In
general. A long-term construction
contract is a home construction contract
if a taxpayer (including a subcontractor
working for a general contractor)
reasonably expects to attribute 80
percent or more of the estimated total
allocable contract costs (including the
cost of land, materials, and services),
determined as of the close of the
contracting year, to the construction
of—
(A) Dwelling units, as defined in
section 168(e)(2)(A)(ii)(I), contained in
buildings containing 4 or fewer
dwelling units (including buildings
with 4 or fewer dwelling units that also
have commercial units); and
(B) Improvements to real property
directly related to, and located at the
site of, the dwelling units.
(ii) Townhouses and rowhouses. Each
townhouse or rowhouse is a separate
building.
(iii) Common improvements. A
taxpayer includes in the cost of the
dwelling units their allocable share of
the cost that the taxpayer reasonably
expects to incur for any common
improvements (e.g., sewers, roads,
clubhouses) that benefit the dwelling
units and that the taxpayer is
contractually obligated, or required by
law, to construct within the tract or
tracts of land that contain the dwelling
units.
(iv) Mixed use costs. If a contract
involves the construction of both
commercial units and dwelling units
within the same building, a taxpayer
must allocate the costs among the
commercial units and dwelling units
using a reasonable method or
combination of reasonable methods,
such as specific identification, square
footage, or fair market value.
(3) $10,000,000 gross receipts test—(i)
In general. Except as otherwise
provided in paragraphs (b)(3)(ii) and
(iii) of this section, the $10,000,000
gross receipts test is satisfied if a
taxpayer’s (or predecessor’s) average
annual gross receipts for the 3 taxable
years preceding the contracting year do
not exceed $10,000,000, as determined
using the principles of the gross receipts
test for small resellers under § 1.263A–
3(b).
(ii) Single employer. To apply the
gross receipts test, a taxpayer is not
required to aggregate the gross receipts
of persons treated as a single employer
solely under section 414(m) and any
regulations prescribed under section
414.
(iii) Attribution of gross receipts. A
taxpayer must aggregate a proportionate

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share of the construction-related gross
receipts of any person that has a five
percent or greater interest in the
taxpayer. In addition, a taxpayer must
aggregate a proportionate share of the
construction-related gross receipts of
any person in which the taxpayer has a
five percent or greater interest. For this
purpose, a taxpayer must determine
ownership interests as of the first day of
the taxpayer’s contracting year and must
include indirect interests in any
corporation, partnership, estate, trust, or
sole proprietorship according to
principles similar to the constructive
ownership rules under sections 1563(e),
(f)(2), and (f)(3)(A). However, a taxpayer
is not required to aggregate under this
paragraph (b)(3)(iii) any constructionrelated gross receipts required to be
aggregated under paragraph (b)(3)(i) of
this section.
(c) Residential construction contracts.
A taxpayer may determine the income
from a long-term construction contract
that is a residential construction
contract using either the PCM or the
percentage-of-completion/capitalizedcost method (PCCM) of accounting
described in § 1.460–4(e). A residential
construction contract is a home
construction contract, as defined in
paragraph (b)(2) of this section, except
that the building or buildings being
constructed contain more than 4
dwelling units.
Par. 7. Section 1.460–4 is amended by
adding paragraphs (a) through (i) to read
as follows:
§ 1.460–4 Methods of accounting for longterm contracts.

(a) Overview. This section prescribes
permissible methods of accounting for
long-term contracts. Paragraph (b) of
this section describes the percentage-ofcompletion method under section
460(b) (PCM) that a taxpayer generally
must use to determine the income from
a long-term contract. Paragraph (c) of
this section lists permissible methods of
accounting for exempt construction
contracts described in § 1.460–3(b)(1)
and describes the exempt-contract
percentage-of-completion method
(EPCM). Paragraph (d) of this section
describes the completed-contract
method (CCM), which is one of the
permissible methods of accounting for
exempt construction contracts.
Paragraph (e) of this section describes
the percentage-of-completion/
capitalized-cost method (PCCM), which
is a permissible method of accounting
for qualified ship contracts described in
§ 1.460–2(d) and residential
construction contracts described in
§ 1.460–3(c). Paragraph (f) of this section
provides rules for determining the

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alternative minimum taxable income
(AMTI) from long-term contracts that
are not exempted under section 56.
Paragraph (g) of this section provides
rules concerning consistency in
methods of accounting for long-term
contracts. Paragraph (h) of this section
provides examples illustrating the
principles of this section. Paragraph (j)
of this section provides rules for
taxpayers that file consolidated tax
returns.
(b) Percentage-of-completion
method—(1) In general. Under the PCM,
a taxpayer generally must include in
income the portion of the total contract
price, as defined in paragraph (b)(4)(i) of
this section, that corresponds to the
percentage of the entire contract that the
taxpayer has completed during the
taxable year. The percentage of
completion must be determined by
comparing allocable contract costs
incurred with estimated total allocable
contract costs. Thus, the taxpayer
includes a portion of the total contract
price in gross income as the taxpayer
incurs allocable contract costs.
(2) Computations. To determine the
income from a long-term contract, a
taxpayer—
(i) Computes the completion factor for
the contract, which is the ratio of the
cumulative allocable contract costs that
the taxpayer has incurred through the
end of the taxable year to the estimated
total allocable contract costs that the
taxpayer reasonably expects to incur
under the contract;
(ii) Computes the amount of
cumulative gross receipts from the
contract by multiplying the completion
factor by the total contract price;
(iii) Computes the amount of currentyear gross receipts, which is the
difference between the amount of
cumulative gross receipts for the current
taxable year and the amount of
cumulative gross receipts for the
immediately preceding taxable year (the
difference can be a positive or negative
number); and
(iv) Takes both the current-year gross
receipts and the allocable contract costs
incurred during the current year into
account in computing taxable income.
(3) Post-completion-year income. If a
taxpayer has not included the total
contract price in gross income by the
completion year, as defined in § 1.460–
1(b)(6), the taxpayer must include the
remaining portion of the total contract
price in gross income for the taxable
year following the completion year. For
the treatment of post-completion costs,
see paragraph (b)(5)(v) of this section.
See § 1.460–6(c)(1)(ii) for application of
the look-back method as a result of
adjustments to total contract price.

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(4) Total contract price—(i) In
general—(A) Definition. Total contract
price means the amount that a taxpayer
reasonably expects to receive under a
long-term contract, including holdbacks,
retainages, and cost reimbursements.
See § 1.460–6(c)(1)(ii) and (2)(vi) for
application of the look-back method as
a result of changes in total contract
price.
(B) Contingent compensation. Any
amount related to a contingent right
under a contract, such as a bonus,
award, incentive payment, and amount
in dispute, is included in total contract
price as soon as the taxpayer can
reasonably predict that the amount will
be earned, even if the all events test has
not yet been met. For example, if a
bonus is payable to a taxpayer for
meeting an early completion date, the
bonus is includible in total contract
price at the time and to the extent that
the taxpayer can reasonably predict the
achievement of the corresponding
objective. Similarly, a portion of the
contract price that is in dispute is
includible in total contract price at the
time and to the extent that the taxpayer
can reasonably predict that the dispute
will be resolved in the taxpayer’s favor
(regardless of when the taxpayer
actually receives payment or when the
dispute is finally resolved). Total
contract price does not include
compensation that might be earned
under any other agreement that the
taxpayer expects to obtain from the
same customer (e.g., exercised option or
follow-on contract) if that other
agreement is not aggregated under
§ 1.460–1(e). For the purposes of this
paragraph (b)(4)(i)(B), a taxpayer can
reasonably predict that an amount of
contingent income will be earned not
later than when the taxpayer includes
that amount in income for financial
reporting purposes under generally
accepted accounting principles. If a
taxpayer has not included an amount of
contingent compensation in total
contract price under this paragraph
(b)(4)(i) by the taxable year following
the completion year, the taxpayer must
account for that amount of contingent
compensation using a permissible
method of accounting. If it is
determined after the taxable year
following the completion year that an
amount included in total contract price
will not be earned, the taxpayer should
deduct that amount in the year of the
determination.
(C) Non-long-term contract activities.
Total contract price includes an
allocable share of the gross receipts
attributable to a non-long-term contract
activity, as defined in § 1.460–1(d)(2), if
the activity is incident to or necessary

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for the manufacture, building,
installation, or construction of the
subject matter of the long-term contract.
Total contract price also includes
amounts reimbursed for independent
research and development expenses (as
defined in § 1.460–1(b)(9)), or for
bidding and proposal costs, under a
federal or cost-plus long-term contract
(as defined in section 460(d)), regardless
of whether the research and
development, or bidding and proposal,
activities are incident to or necessary for
the performance of that long-term
contract.
(ii) Estimating total contract price. A
taxpayer must estimate the total contract
price based upon all the facts and
circumstances known as of the last day
of the taxable year. For this purpose, an
event that occurs after the end of the
taxable year must be taken into account
if its occurrence was reasonably
predictable and its income was subject
to reasonable estimation as of the last
day of that taxable year.
(5) Completion factor—(i) Allocable
contract costs. A taxpayer must use a
cost allocation method permitted under
either § 1.460–5(b) or (c) to determine
the amount of cumulative allocable
contract costs and estimated total
allocable contract costs that are used to
determine a contract’s completion
factor. Allocable contract costs include
a reimbursable cost that is allocable to
the contract.
(ii) Cumulative allocable contract
costs. To determine a contract’s
completion factor for a taxable year, a
taxpayer must take into account the
cumulative allocable contract costs that
have been incurred, as defined in
§ 1.460–1(b)(8), through the end of the
taxable year.
(iii) Estimating total allocable
contract costs. A taxpayer must estimate
total allocable contract costs for each
long-term contract based upon all the
facts and circumstances known as of the
last day of the taxable year. For this
purpose, an event that occurs after the
end of the taxable year must be taken
into account if its occurrence was
reasonably predictable and its cost was
subject to reasonable estimation as of
the last day of that taxable year. To be
considered reasonable, an estimate of
total allocable contract costs must
include costs attributable to delay,
rework, change orders, technology or
design problems, or other problems that
reasonably can be predicted considering
the nature of the contract and prior
experience. However, estimated total
allocable contract costs do not include
any contingency allowance for costs
that, as of the end of the taxable year,
are not reasonably predicted to be

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incurred in the performance of the
contract. For example, estimated total
allocable contract costs do not include
any costs attributable to factors not
reasonably predictable at the end of the
taxable year, such as third-party
litigation, extreme weather conditions,
strikes, and delays in securing required
permits and licenses. In addition, the
estimated costs of performing other
agreements that are not aggregated with
the contract under § 1.460–1(e) that the
taxpayer expects to incur with the same
customer (e.g., follow-on contracts) are
not included in estimated total allocable
contract costs for the initial contract.
(iv) Pre-contracting-year costs. If a
taxpayer reasonably expects to enter
into a long-term contract in a future
taxable year, the taxpayer must
capitalize all costs incurred prior to
entering into the contract that will be
allocable to that contract (e.g., bidding
and proposal costs). A taxpayer is not
required to compute a completion
factor, or to include in gross income any
amount, related to allocable contract
costs for any taxable year ending before
the contracting year or, if applicable, the
10-percent year defined in paragraph
(b)(6)(i) of this section. In that year, the
taxpayer is required to compute a
completion factor that includes all
allocable contract costs that have been
incurred as of the end of that taxable
year (whether previously capitalized or
deducted) and to take into account in
computing taxable income the related
gross receipts and the previously
capitalized allocable contract costs. If,
however, a taxpayer determines in a
subsequent year that it will not enter
into the long-term contract, the taxpayer
must account for these pre-contractingyear costs in that year (e.g., as a
deduction or an inventoriable cost)
using the appropriate rules contained in
other sections of the Code or
regulations.
(v) Post-completion-year costs. If a
taxpayer incurs an allocable contract
cost after the completion year, the
taxpayer must account for that cost
using a permissible method of
accounting. See § 1.460–6(c)(1)(ii) for
application of the look-back method as
a result of adjustments to allocable
contract costs.
(6) 10-percent method—(i) In general.
Instead of determining the income from
a long-term contract beginning with the
contracting year, a taxpayer may elect to
use the 10-percent method under
section 460(b)(5). Under the 10-percent
method, a taxpayer does not include in
gross income any amount related to
allocable contract costs until the taxable
year in which the taxpayer has incurred
at least 10 percent of the estimated total

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allocable contract costs (10-percent
year). A taxpayer must treat costs
incurred before the 10-percent year as
pre-contracting-year costs described in
paragraph (b)(5)(iv) of this section.
(ii) Election. A taxpayer makes an
election under this paragraph (b)(6) by
using the 10-percent method for all
long-term contracts entered into during
the taxable year of the election on its
original federal income tax return for
the election year. This election is a
method of accounting and, thus, applies
to all long-term contracts entered into
during and after the taxable year of the
election. An electing taxpayer must use
the 10-percent method to apply the
look-back method under § 1.460–6 and
to determine alternative minimum
taxable income under paragraph (f) of
this section. This election is not
available if a taxpayer uses the
simplified cost-to-cost method
described in § 1.460-5(c) to compute the
completion factor of a long-term
contract.
(7) Terminated contract—(i) Reversal
of income. If a long-term contract is
terminated before completion and, as a
result, the taxpayer retains ownership of
the property that is the subject matter of
that contract, the taxpayer must reverse
the transaction in the taxable year of
termination. To reverse the transaction,
the taxpayer reports a loss (or gain)
equal to the cumulative allocable
contract costs reported under the
contract in all prior taxable years less
the cumulative gross receipts reported
under the contract in all prior taxable
years.
(ii) Adjusted basis. As a result of
reversing the transaction under
paragraph (b)(7)(i) of this section, a
taxpayer will have an adjusted basis in
the retained property equal to the
cumulative allocable contract costs
reported under the contract in all prior
taxable years. However, if the taxpayer
received and retains any consideration
or compensation from the customer, the
taxpayer must reduce the adjusted basis
in the retained property (but not below
zero) by the fair market value of that
consideration or compensation. To the
extent that the amount of the
consideration or compensation
described in the preceding sentence
exceeds the adjusted basis in the
retained property, the taxpayer must
include the excess in gross income for
the taxable year of termination.
(iii) Look-back method. The look-back
method does not apply to a terminated
contract that is subject to this paragraph
(b)(7).
(c) Exempt contract methods—(1) In
general. An exempt contract method
means the method of accounting that a

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taxpayer must use to account for all its
long-term contracts (and any portion of
a long-term contract) that are exempt
from the requirements of section 460(a).
Thus, an exempt contract method
applies to exempt construction
contracts, as defined in § 1.460–3(b); the
non-PCM portion of a qualified ship
contract, as defined in § 1.460–2(d); and
the non-PCM portion of a residential
construction contract, as defined in
§ 1.460–3(c). Permissible exempt
contract methods include the PCM, the
EPCM described in paragraph (c)(2) of
this section, the CCM described in
paragraph (d) of this section, or any
other permissible method. See section
446.
(2) Exempt-contract percentage-ofcompletion method—(i) In general.
Similar to the PCM described in
paragraph (b) of this section, a taxpayer
using the EPCM generally must include
in income the portion of the total
contract price, as described in paragraph
(b)(4) of this section, that corresponds to
the percentage of the entire contract that
the taxpayer has completed during the
taxable year. However, under the EPCM,
the percentage of completion may be
determined as of the end of the taxable
year by using any method of cost
comparison (such as comparing direct
labor costs incurred to date to estimated
total direct labor costs) or by comparing
the work performed on the contract with
the estimated total work to be
performed, rather than by using the
cost-to-cost comparison required by
paragraphs (b)(2)(i) and (5) of this
section, provided such method is used
consistently and clearly reflects income.
In addition, paragraph (b)(3) of this
section (regarding post-completion-year
income), paragraph (b)(6) of this section
(regarding the 10-percent method) and
§ 1.460–6 (regarding the look-back
method) do not apply to the EPCM.
(ii) Determination of work performed.
For purposes of the EPCM, the criteria
used to compare the work performed on
a contract as of the end of the taxable
year with the estimated total work to be
performed must clearly reflect the
earning of income with respect to the
contract. For example, in the case of a
roadbuilder, a standard of completion
solely based on miles of roadway
completed in a case where the terrain is
substantially different may not clearly
reflect the earning of income with
respect to the contract.
(d) Completed-contract method—(1)
In general. Except as otherwise
provided in paragraph (d)(4) of this
section, a taxpayer using the CCM to
account for a long-term contract must
take into account in the contract’s
completion year, as defined in § 1.460–

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1(b)(6), the gross contract price and all
allocable contract costs incurred by the
completion year. A taxpayer may not
treat the cost of any materials and
supplies that are allocated to a contract,
but actually remain on hand when the
contract is completed, as an allocable
contract cost.
(2) Post-completion-year income and
costs. If a taxpayer has not included an
item of contingent compensation (i.e.,
amounts for which the all events test
has not been satisfied) in gross contract
price under paragraph (d)(3) of this
section by the completion year, the
taxpayer must account for this item of
contingent compensation using a
permissible method of accounting. If a
taxpayer incurs an allocable contract
cost after the completion year, the
taxpayer must account for that cost
using a permissible method of
accounting.
(3) Gross contract price. Gross
contract price includes all amounts
(including holdbacks, retainages, and
reimbursements) that a taxpayer is
entitled by law or contract to receive,
whether or not the amounts are due or
have been paid. In addition, gross
contract price includes all bonuses,
awards, and incentive payments, such
as a bonus for meeting an early
completion date, to the extent the all
events test is satisfied. If a taxpayer
performs a non-long-term contract
activity, as defined in § 1.460–1(d)(2),
that is incident to or necessary for the
manufacture, building, installation, or
construction of the subject matter of one
or more of the taxpayer’s long-term
contracts, the taxpayer must include an
allocable share of the gross receipts
attributable to that activity in the gross
contract price of the contract(s)
benefitted by that activity. Gross
contract price also includes amounts
reimbursed for independent research
and development expenses (as defined
in § 1.460–1(b)(9)), or bidding and
proposal costs, under a federal or costplus long-term contract (as defined in
section 460(d)), regardless of whether
the research and development, or
bidding and proposal, activities are
incident to or necessary for the
performance of that long-term contract.
(4) Contracts with disputed claims—
(i) In general. The special rules in this
paragraph (d)(4) apply to a long-term
contract accounted for using the CCM
with a dispute caused by a customer’s
requesting a reduction of the gross
contract price or the performance of
additional work under the contract or by
a taxpayer’s requesting an increase in
gross contract price, or both, on or after
the date a taxpayer has tendered the

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subject matter of the contract to the
customer.
(ii) Taxpayer assured of profit or loss.
If the disputed amount relates to a
customer’s claim for either a reduction
in price or additional work and the
taxpayer is assured of either a profit or
a loss on a long-term contract regardless
of the outcome of the dispute, the gross
contract price, reduced (but not below
zero) by the amount reasonably in
dispute, must be taken into account in
the completion year. If the disputed
amount relates to a taxpayer’s claim for
an increase in price and the taxpayer is
assured of either a profit or a loss on a
long-term contract regardless of the
outcome of the dispute, the gross
contract price must be taken into
account in the completion year. If the
taxpayer is assured a profit on the
contract, all allocable contract costs
incurred by the end of the completion
year are taken into account in that year.
If the taxpayer is assured a loss on the
contract, all allocable contract costs
incurred by the end of the completion
year, reduced by the amount reasonably
in dispute, are taken into account in the
completion year.
(iii) Taxpayer unable to determine
profit or loss. If the amount reasonably
in dispute affects so much of the gross
contract price or allocable contract costs
that a taxpayer cannot determine
whether a profit or loss ultimately will
be realized from a long-term contract,
the taxpayer may not take any of the
gross contract price or allocable contract
costs into account in the completion
year.
(iv) Dispute resolved. Any part of the
gross contract price and any allocable
contract costs that have not been taken
into account because of the principles
described in paragraph (d)(4)(i), (ii), or
(iii) of this section must be taken into
account in the taxable year in which the
dispute is resolved. If a taxpayer
performs additional work under the
contract because of the dispute, the term
taxable year in which the dispute is
resolved means the taxable year the
additional work is completed, rather
than the taxable year in which the
outcome of the dispute is determined by
agreement, decision, or otherwise.
(e) Percentage-of-completion/
capitalized-cost method. Under the
PCCM, a taxpayer must determine the
income from a long-term contract using
the PCM for the applicable percentage of
the contract and its exempt contract
method, as defined in paragraph (c) of
this section, for the remaining
percentage of the contract. For
residential construction contracts
described in § 1.460–3(c), the applicable
percentage is 70 percent, and the

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remaining percentage is 30 percent. For
qualified ship contracts described in
§ 1.460–2(d), the applicable percentage
is 40 percent, and the remaining
percentage is 60 percent.
(f) Alternative minimum taxable
income—(1) In general. Under section
56(a)(3), a taxpayer (not exempt from
the AMT under section 55(e)) must use
the PCM to determine its AMTI from
any long-term contract entered into on
or after March 1, 1986, that is not a
home construction contract, as defined
in § 1.460–3(b)(2). For AMTI purposes,
the PCM must include any election
under paragraph (b)(6) of this section
(concerning the 10-percent method) or
under § 1.460–5(c) (concerning the
simplified cost-to-cost method) that the
taxpayer has made for regular tax
purposes. For exempt construction
contracts described in § 1.460–
3(b)(1)(ii), a taxpayer must use the
simplified cost-to-cost method to
determine the completion factor for
AMTI purposes. Except as provided in
paragraph (f)(2) of this section, a
taxpayer must use AMTI costs and
AMTI methods, such as the depreciation
method described in section 56(a)(1), to
determine the completion factor of a
long-term contract (except a home
construction contract) for AMTI
purposes.
(2) Election to use regular completion
factors. Under this paragraph (f)(2), a
taxpayer may elect for AMTI purposes
to determine the completion factors of
all of its long-term contracts using the
methods of accounting and allocable
contract costs used for regular federal
income tax purposes. A taxpayer makes
this election by using regular methods
and regular costs to compute the

completion factors of all long-term
contracts entered into during the taxable
year of the election for AMTI purposes
on its original federal income tax return
for the election year. This election is a
method of accounting and, thus, applies
to all long-term contracts entered into
during and after the taxable year of the
election. Although a taxpayer may elect
to compute the completion factor of its
long-term contracts using regular
methods and regular costs, an election
under this paragraph (f)(2) does not
eliminate a taxpayer’s obligation to
comply with the requirements of section
55 when computing AMTI. For
example, although a taxpayer may elect
to use the depreciation methods used
for regular tax purposes to compute the
completion factor of its long-term
contracts for AMTI purposes, the
taxpayer must use the depreciation
methods permitted by section 56 to
compute AMTI.
(g) Method of accounting. A taxpayer
that uses the PCM, EPCM, CCM, PCCM,
or elects the 10-percent method or
special AMTI method (or changes to
another method of accounting with the
Commissioner’s consent) must apply the
method(s) consistently for all similarly
classified long-term contracts, until the
taxpayer obtains the Commissioner’s
consent under section 446(e) to change
to another method of accounting. A
taxpayer-initiated change in method of
accounting will be permitted only on a
cut-off basis (i.e., for contracts entered
into on or after the year of change), and
thus, a section 481(a) adjustment will
not be permitted or required.
(h) Examples. The following examples
illustrate the rules of this section:

2235

Example 1. PCM—estimating total contract
price. C, whose taxable year ends December
31, determines the income from long-term
contracts using the PCM. On January 1, 2001,
C enters into a contract to design and
manufacture a satellite (a unique item). The
contract provides that C will be paid
$10,000,000 for delivering the completed
satellite by December 1, 2002. The contract
also provides that C will receive a $3,000,000
bonus for delivering the satellite by July 1,
2002, and an additional $4,000,000 bonus if
the satellite successfully performs its mission
for five years. C is unable to reasonably
predict if the satellite will successfully
perform its mission for five years. If on
December 31, 2001, C should reasonably
expect to deliver the satellite by July 1, 2002,
the estimated total contract price is
$13,000,000 ($10,000,000 unit price +
$3,000,000 production-related bonus).
Otherwise, the estimated total contract price
is $10,000,000. In either event, the
$4,000,000 bonus is not includible in the
estimated total contract price as of December
31, 2001, because C is unable to reasonably
predict that the satellite will successfully
perform its mission for five years.
Example 2. PCM—computing income. (i) C,
whose taxable year ends December 31,
determines the income from long-term
contracts using the PCM. During 2001, C
agrees to manufacture for the customer, B, a
unique item for a total contract price of
$1,000,000. Under C’s contract, B is entitled
to retain 10 percent of the total contract price
until it accepts the item. By the end of 2001,
C has incurred $200,000 of allocable contract
costs and estimates that the total allocable
contract costs will be $800,000. By the end
of 2002, C has incurred $600,000 of allocable
contract costs and estimates that the total
allocable contract costs will be $900,000. In
2003, after completing the contract, C
determines that the actual cost to
manufacture the item was $750,000.
(ii) For each of the taxable years, C’s
income from the contract is computed as
follows:
Taxable Year
2001

2002

2003

(A) Cumulative incurred costs ...........................................................................................................
(B) Estimated total costs ...................................................................................................................

$200,000
800,000

$600,000
900,000

$750,000
750,000

(C) Completion factor: (A) ÷ (B) ........................................................................................................

25.00%

66.67%

100.00%

(D) Total contract price ......................................................................................................................

1,000,000

1,000,000

1,000,000

(E) Cumulative gross receipts: (C) × (D) ...........................................................................................
(F) Cumulative gross receipts (prior year) ........................................................................................

250,000
(0)

666,667
(250,000)

1,000,000
(666,667)

(G) Current-year gross receipts .........................................................................................................

250,000

416,667

333,333

(H) Cumulative incurred costs ...........................................................................................................
(I) Cumulative incurred costs (prior year) ..........................................................................................

200,000
(0)

600,000
(200,000)

750,000
(600,000)

(J) Current-year costs ........................................................................................................................

200,000

400,000

150,000

(K) Gross income: (G) ¥ (J) .............................................................................................................

$50,000

$16,667

$183,333

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Example 3. PCM—computing income with
cost sharing. (i) C, whose taxable year ends
December 31, determines the income from
long-term contracts using the PCM. During
2001, C enters into a contract to manufacture
a unique item. The contract specifies a target
price of $1,000,000, a target cost of $600,000,
and a target profit of $400,000. C and B will
share the savings of any cost underrun
(actual total incurred cost is less than target

cost) and the additional cost of any cost
overrun (actual total incurred cost is greater
than target cost) as follows: 30 percent to C
and 70 percent to B. By the end of 2001, C
has incurred $200,000 of allocable contract
costs and estimates that the total allocable
contract costs will be $600,000. By the end
of 2002, C has incurred $300,000 of allocable
contract costs and estimates that the total
allocable contract costs will be $400,000. In

2003, after completing the contract, C
determines that the actual cost to
manufacture the item was $700,000.
(ii) For each of the taxable years, C’s
income from the contract is computed as
follows (note that the sharing of any cost
underrun or cost overrun is reflected as an
adjustment to C’s target price under
paragraph (b)(4)(i) of this section):
Taxable Year
2001

2002

2003

(A) Cumulative incurred costs ...........................................................................................................
(B) Estimated total costs ...................................................................................................................

$200,000
600,000

$300,000
400,000

$700,000
700,000

(C) Completion factor: (A) ÷ (B) ........................................................................................................

33.33%

75.00%

100.00%

(D) Target price .................................................................................................................................

$1,000,000

$1,000,000

$1,000,000

(E) Estimated total costs ...................................................................................................................
(F) Target costs .................................................................................................................................

600,000
600,000

400,000
600,000

700,000
600,000

(G) Cost (underrun)/overrun: (E) ¥ (F) ............................................................................................
(H) Adjustment rate ...........................................................................................................................

0
70%

(200,000)
70%

100,000
70%

(I) Target price adjustment ................................................................................................................

0

(140,000)

70,000

(J) Total contract price: (D) + (I) ........................................................................................................

$1,000,000

$860,000

$1,070,000
$1,070,000
(645,000)

(K) Cumulative gross receipts: (C) × (J) ...........................................................................................
(L) Cumulative gross receipts (prior year): ........................................................................................

$333,333
(0)

$645,000
(333,333)

(M) Current-year gross receipts ........................................................................................................

333,333

311,667

425,000

(N) Cumulative incurred costs ...........................................................................................................
(O) Cumulative incurred costs (prior year): .......................................................................................

200,000
(0)

300,000
(200,000)

700,000
(300,000)

(P) Current-year costs .......................................................................................................................

200,000

100,000

400,000

(Q) Gross income: (M) ¥ (P) ............................................................................................................

$133,333

$211,667

$25,000

Example 4. PCM—10 percent method. (i) C,
whose taxable year ends December 31,
determines the income from long-term
contracts using the PCM. In November 2001,
C agrees to manufacture a unique item for
$1,000,000. C reasonably estimates that the
total allocable contract costs will be

$600,000. By December 31, 2001, C has
received $50,000 in progress payments and
incurred $40,000 of costs. C elects to use the
10 percent method effective for 2001 and all
subsequent taxable years. During 2002, C
receives $500,000 in progress payments and
incurs $260,000 of costs. In 2003, C incurs an

additional $300,000 of costs, C finishes
manufacturing the item, and receives the
final $450,000 payment.
(ii) For each of the taxable years, C’s
income from the contract is computed as
follows:
Taxable Year
2001

2002

2003

(A) Cumulative incurred costs ...........................................................................................................
(B) Estimated total costs ...................................................................................................................

$40,000
600,000

$300,000
600,000

$600,000
600,000

(C) Completion factor (A) ÷ (B) .........................................................................................................

6.67%

50.00%

100.00%

(D) Total contract price ......................................................................................................................

1,000,000

1,000,000

1,000,000

(E) Cumulative gross receipts: (C) × (D)* .........................................................................................
(F) Cumulative gross receipts (prior year): .......................................................................................

0
(0)

500,000
(0)

1,000,000
(500,000)

(G) Current-year gross receipts .........................................................................................................

0

500,000

500,000

(H) Cumulative incurred costs ...........................................................................................................
(I) Cumulative incurred costs (prior year): .........................................................................................

0
(0)

300,000
(0)

600,000
(300,000)

(J) Current-year costs ........................................................................................................................

0

300,000

300,000

(K) Gross income: (G) ¥ (J) .............................................................................................................

$0

$200,000

$200,000

*Unless (C) <10 percent.

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Federal Register / Vol. 66, No. 8 / Thursday, January 11, 2001 / Rules and Regulations
Example 5. PCM—contract terminated. C,
whose taxable year ends December 31,
determines the income from long-term
contracts using the PCM. During 2001, C
buys land and begins constructing a building
that will contain 50 condominium units on
that land. C enters into a contract to sell one
unit in this condominium to B for $240,000.
B gives C a $5,000 deposit toward the
purchase price. By the end of 2001, C has
incurred $50,000 of allocable contract costs
on B’s unit and estimates that the total
allocable contract costs on B’s unit will be
$150,000. Thus, for 2001, C reports gross
receipts of $80,000 ($50,000 ÷ $150,000 ×
$240,000), current-year costs of $50,000, and
gross income of $30,000 ($80,000—$50,000).
In 2002, after C has incurred an additional
$25,000 of allocable contract costs on B’s
unit, B files for bankruptcy protection and
defaults on the contract with C, who is
permitted to keep B’s $5,000 deposit as
liquidated damages. In 2002, C reverses the
transaction with B under paragraph (b)(7) of
this section and reports a loss of $30,000
($50,000–$80,000). In addition, C obtains an
adjusted basis in the unit sold to B of $70,000
($50,000 (current-year costs deducted in
2001)—$5,000 (B’s forfeited deposit) +
$25,000 (current-year costs incurred in 2002).
C may not apply the look-back method to this
contract in 2002.
Example 6. CCM—contracts with disputes
from customer claims. In 2001, C, whose
taxable year ends December 31, uses the CCM
to account for exempt construction contracts.
C enters into a contract to construct a bridge
for B. The terms of the contract provide for
a $1,000,000 gross contract price. C finishes
the bridge in 2002 at a cost of $950,000.
When B examines the bridge, B insists that
C either repaint several girders or reduce the
contract price. The amount reasonably in
dispute is $10,000. In 2003, C and B resolve
their dispute, C repaints the girders at a cost
of $6,000, and C and B agree that the contract
price is not to be reduced. Because C is
assured a profit of $40,000 ($1,000,000—
$10,000—$950,000) in 2002 even if the
dispute is resolved in B’s favor, C must take
this $40,000 into account in 2002. In 2003,
C will earn an additional $4,000 profit
($1,000,000—$956,000—$40,000) from the
contract with B. Thus, C must take into
account an additional $10,000 of gross
contract price and $6,000 of additional
contract costs in 2003.
Example 7. CCM—contracts with disputes
from taxpayer claims. In 2003, C, whose
taxable year ends December 31, uses the CCM
to account for exempt construction contracts.
C enters into a contract to construct a
building for B. The terms of the contract
provide for a $1,000,000 gross contract price.
C finishes the building in 2004 at a cost of
$1,005,000. B examines the building in 2004
and agrees that it meets the contract’s
specifications; however, at the end of 2004,
C and B are unable to agree on the merits of
C’s claim for an additional $10,000 for items
that C alleges are changes in contract
specifications and B alleges are within the
scope of the contract’s original specifications.
In 2005, B agrees to pay C an additional
$2,000 to satisfy C’s claims under the
contract. Because the amount in dispute

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affects so much of the gross contract price
that C cannot determine in 2004 whether a
profit or loss will ultimately be realized, C
may not taken any of the gross contract price
or allocable contract costs into account in
2004. C must take into account $1,002,000 of
gross contract price and $1,005,000 of
allocable contract costs in 2005.
Example 8. CCM—contracts with disputes
from taxpayer and customer claims. C,
whose taxable year ends December 31, uses
the CCM to account for exempt construction
contracts. C constructs a factory for B
pursuant to a long-term contract. Under the
terms of the contract, B agrees to pay C a total
of $1,000,000 for construction of the factory.
C finishes construction of the factory in 2002
at a cost of $1,020,000. When B takes
possession of the factory and begins
operations in December 2002, B is
dissatisfied with the location and
workmanship of certain heating ducts. As of
the end of 2002, C contends that the heating
ducts are constructed in accordance with
contract specifications. The amount of the
gross contract price reasonably in dispute
with respect to the heating ducts is $6,000.
As of this time, C is claiming $14,000 in
addition to the original contract price for
certain changes in contract specifications
which C alleges have increased his costs. B
denies that these changes have increased C’s
costs. In 2003, the disputes between C and
B are resolved by performance of additional
work by C at a cost of $1,000 and by an
agreement that the contract price would be
revised downward to $996,000. Under these
circumstances, C must include in his gross
income for 2002, $994,000 (the gross contract
price less the amount reasonably in dispute
because of B’s claim, or $1,000,000—$6,000).
In 2002, C must also take into account
$1,000,000 of allocable contract costs (costs
incurred less the amounts in dispute
attributable to both B’s and C’s claims, or
$1,020,000—$6,000—$14,000). In 2003, C
must take into account an additional $2,000
of gross contract price ($996,000—$994,000)
and $21,000 of allocable contract costs
($1,021,000—$1,000,000).

(i) [Reserved]
*
*
*
*
(k) Mid-contract change in taxpayer.
[Reserved]
Par. 8. Section 1.460–5 is added to
read as follows:
*

§ 1.460–5

Cost allocation rules.

(a) Overview. This section prescribes
methods of allocating costs to long-term
contracts accounted for using the
percentage-of-completion method
described in § 1.460–4(b) (PCM), the
completed-contract method described in
§ 1.460–4(d) (CCM), or the percentageof-completion/capitalized-cost method
described in § 1.460–4(e) (PCCM).
Exempt construction contracts
described in § 1.460–3(b) accounted for
using a method other than the PCM or
CCM are not subject to the cost
allocation rules of this section (other
than the requirement to allocate

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2237

production-period interest under
paragraph (b)(2)(v) of this section).
Paragraph (b) of this section describes
the regular cost allocation methods for
contracts subject to the PCM. Paragraph
(c) of this section describes an elective
simplified cost allocation method for
contracts subject to the PCM. Paragraph
(d) of this section describes the cost
allocation methods for exempt
construction contracts reported using
the CCM. Paragraph (e) of this section
describes the cost allocation rules for
contracts subject to the PCCM.
Paragraph (f) of this section describes
additional rules applicable to the cost
allocation methods described in this
section. Paragraph (g) of this section
provides rules concerning consistency
in method of allocating costs to longterm contracts.
(b) Cost allocation method for
contracts subject to PCM—(1) In
general. Except as otherwise provided
in paragraph (b)(2) of this section, a
taxpayer must allocate costs to each
long-term contract subject to the PCM in
the same manner that direct and
indirect costs are capitalized to property
produced by a taxpayer under § 1.263A–
1(e) through (h). Thus, a taxpayer must
allocate to each long-term contract
subject to the PCM all direct costs and
certain indirect costs properly allocable
to the long-term contract (i.e., all costs
that directly benefit or are incurred by
reason of the performance of the longterm contract). However, see paragraph
(c) of this section concerning an election
to allocate contract costs using the
simplified cost-to-cost method. As in
section 263A, the use of the practical
capacity concept is not permitted. See
§ 1.263A–2(a)(4).
(2) Special rules—(i) Direct material
costs. The costs of direct materials must
be allocated to a long-term contract
when dedicated to the contract under
principles similar to those in § 1.263A–
11(b)(2). Thus, a taxpayer dedicates
direct materials by associating them
with a specific contract, including by
purchase order, entry on books and
records, or shipping instructions. A
taxpayer maintaining inventories under
§ 1.471–1 must determine allocable
contract costs attributable to direct
materials using its method of accounting
for those inventories (e.g., FIFO, LIFO,
specific identification).
(ii) Components and subassemblies.
The costs of a component or
subassembly (component) produced by
the taxpayer must be allocated to a longterm contract as the taxpayer incurs
costs to produce the component if the
taxpayer reasonably expects to
incorporate the component into the
subject matter of the contract. Similarly,

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the cost of a purchased component
(including a component purchased from
a related party) must be allocated to a
long-term contract as the taxpayer
incurs the cost to purchase the
component if the taxpayer reasonably
expects to incorporate the component
into the subject matter of the contract.
In all other cases, the cost of a
component must be allocated to a longterm contract when the component is
dedicated, under principles similar to
those in § 1.263A–11(b)(2). A taxpayer
maintaining inventories under § 1.471–
1 must determine allocable contract
costs attributable to components using
its method of accounting for those
inventories (e.g., FIFO, LIFO, specific
identification).
(iii) Simplified production methods. A
taxpayer may not determine allocable
contract costs using the simplified
production methods described in
§ 1.263A–2(b) and (c).
(iv) Costs identified under cost-plus
long-term contracts and federal longterm contracts. To the extent not
otherwise allocated to the contract
under this paragraph (b), a taxpayer
must allocate any identified costs to a
cost-plus long-term contract or federal
long-term contract (as defined in section
460(d)). Identified cost means any cost,
including a charge representing the
time-value of money, identified by the
taxpayer or related person as being
attributable to the taxpayer’s cost-plus
long-term contract or federal long-term
contract under the terms of the contract
itself or under federal, state, or local law
or regulation.
(v) Interest—(A) In general. If
property produced under a long-term
contract is designated property, as
defined in § 1.263A–8(b) (without
regard to the exclusion for long-term
contracts under § 1.263A–8(d)(2)(v)), a
taxpayer must allocate interest incurred
during the production period to the
long-term contract in the same manner
as interest is allocated to property
produced by a taxpayer under section
263A(f). See §§ 1.263A–8 to 1.263A–12
generally.
(B) Production period.
Notwithstanding § 1.263A–12(c) and (d),
for purposes of this paragraph (b)(2)(v),
the production period of a long-term
contract—
(1) Begins on the later of—
(i) The contract commencement date,
as defined in § 1.460–1(b)(7); or
(ii) For a taxpayer using the accrual
method of accounting for long-term
contracts, the date by which 5 percent
or more of the total estimated costs,
including design and planning costs,
under the contract have been incurred;
and

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(2) Ends on the date that the contract
is completed, as defined in § 1.460–
1(c)(3).
(C) Application of section 263A(f). For
purposes of this paragraph (b)(2)(v),
section 263A(f)(1)(B)(iii) (regarding an
estimated production period exceeding
1 year and a cost exceeding $1,000,000)
must be applied on a contract-bycontract basis; except that, in the case of
a taxpayer using an accrual method of
accounting, that section must be applied
on a property-by-property basis.
(vi) Research and experimental
expenses. Notwithstanding § 1.263A–
1(e)(3)(ii)(P) and (iii)(B), a taxpayer must
allocate research and experimental
expenses, other than independent
research and development expenses (as
defined in § 1.460–1(b)(9)), to its longterm contracts.
(vii) Service costs—(A) Simplified
service cost method—(1) In general. To
use the simplified service cost method
under § 1.263A–1(h), a taxpayer must
allocate the otherwise capitalizable
mixed service costs among its long-term
contracts using a reasonable method.
For example, otherwise capitalizable
mixed service costs may be allocated to
each long-term contract based on labor
hours or contract costs allocable to the
contract. To be considered reasonable,
an allocation method must be applied
consistently and must not
disproportionately allocate service costs
to contracts expected to be completed in
the near future.
(2) Example. The following example
illustrates the rule of this paragraph
(b)(2)(vii)(A):
Example. Simplified service cost method.
During 2001, C, whose taxable year ends
December 31, produces electronic equipment
for inventory and enters into long-term
contracts to manufacture specialized
electronic equipment. C’s method of
allocating mixed service costs to the property
it produces is the labor-based, simplified
service cost method described in § 1.263A–
1(h)(4). For 2001, C’s total mixed service
costs are $100,000, C’s section 263A labor
costs are $500,000, C’s section 460 labor costs
(i.e., labor costs allocable to C’s long-term
contracts) are $250,000, and C’s total labor
costs are $1,000,000. To determine the
amount of mixed service costs capitalizable
under section 263A for 2001, C multiplies its
total mixed service costs by its section 263A
allocation ratio (section 263A labor costs ÷
total labor costs). Thus, C’s capitalizable
mixed service costs for 2001 are $50,000
($100,000 x $500,000 ÷ $1,000,000).
Thereafter, C allocates its capitalizable mixed
service costs to produced property remaining
in ending inventory using its 263A allocation
method (e.g., burden rate, simplified
production). Similarly, to determine the
amount of mixed service costs that are
allocable to C’s long-term contracts for 2001,
C multiplies its total mixed service costs by

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its section 460 allocation ratio (section 460
labor ÷ total labor costs). Thus, C’s allocable
mixed service contract costs for 2001 are
$25,000 ($100,000 x $250,000 ÷ $1,000,000).
Thereafter, C allocates its allocable mixed
service costs to its long-term contracts
proportionately based on its section 460 labor
costs allocable to each long-term contract.

(B) Jobsite costs. If an administrative,
service, or support function is
performed solely at the jobsite for a
specific long-term contract, the taxpayer
may allocate all the direct and indirect
costs of that administrative, service, or
support function to that long-term
contract. Similarly, if an administrative,
service, or support function is
performed at the jobsite solely for the
taxpayer’s long-term contract activities,
the taxpayer may allocate all the direct
and indirect costs of that administrative,
service, or support function among all
the long-term contracts performed at
that jobsite. For this purpose, jobsite
means a production plant or a
construction site.
(C) Limitation on other reasonable
cost allocation methods. A taxpayer
may use any other reasonable method of
allocating service costs, as provided in
§ 1.263A–1(f)(4), if, for the taxpayer’s
long-term contracts considered as a
whole, the—
(1) Total amount of service costs
allocated to the contracts does not differ
significantly from the total amount of
service costs that would have been
allocated to the contracts under
§ 1.263A–1(f)(2) or (3);
(2) Service costs are not allocated
disproportionately to contracts expected
to be completed in the near future
because of the taxpayer’s cost allocation
method; and
(3) Taxpayer’s cost allocation method
is applied consistently.
(c) Simplified cost-to-cost method for
contracts subject to the PCM—(1) In
general. Instead of using the cost
allocation method prescribed in
paragraph (b) of this section, a taxpayer
may elect to use the simplified cost-tocost method, which is authorized under
section 460(b)(3)(A), to allocate costs to
a long-term contract subject to the PCM.
Under the simplified cost-to-cost
method, a taxpayer determines a
contract’s completion factor based upon
only direct material costs; direct labor
costs; and depreciation, amortization,
and cost recovery allowances on
equipment and facilities directly used to
manufacture or construct the subject
matter of the contract. For this purpose,
the costs associated with any
manufacturing or construction activities
performed by a subcontractor are
considered either direct material or
direct labor costs, as appropriate, and

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Federal Register / Vol. 66, No. 8 / Thursday, January 11, 2001 / Rules and Regulations
therefore must be allocated to the
contract under the simplified cost-tocost method. An electing taxpayer must
use the simplified cost-to-cost method
to apply the look-back method under
§ 1.460–6 and to determine alternative
minimum taxable income under
§ 1.460–4(f).
(2) Election. A taxpayer makes an
election under this paragraph (c) by
using the simplified cost-to-cost method
for all long-term contracts entered into
during the taxable year of the election
on its original federal income tax return
for the election year. This election is a
method of accounting and, thus, applies
to all long-term contracts entered into
during and after the taxable year of the
election. This election is not available if
a taxpayer does not use the PCM to
account for all long-term contracts or if
a taxpayer elects to use the 10-percent
method described in § 1.460–4(b)(6).
(d) Cost allocation rules for exempt
construction contracts reported using
the CCM—(1) In general. For exempt
construction contracts reported using
the CCM, other than contracts described
in paragraph (d)(3) of this section
(concerning contracts of homebuilders
that do not satisfy the $10,000,000 gross
receipts test described in § 1.460–3(b)(3)
or will not be completed within two
years of the contract commencement
date), a taxpayer must annually allocate
the cost of any activity that is incident
to or necessary for the taxpayer’s
performance under a long-term contract.
A taxpayer must allocate to each exempt
construction contract all direct costs as
defined in § 1.263A–1(e)(2)(i) and all
indirect costs either as provided in
§ 1.263A–1(e)(3) or as provided in
paragraph (d)(2) of this section.
(2) Indirect costs—(i) Indirect costs
allocable to exempt construction
contracts. A taxpayer allocating costs
under this paragraph (d)(2) must
allocate the following costs to an
exempt construction contract, other
than a contract described in paragraph
(d)(3) of this section, to the extent
incurred in the performance of that
contract—
(A) Repair of equipment or facilities;
(B) Maintenance of equipment or
facilities;
(C) Utilities, such as heat, light, and
power, allocable to equipment or
facilities;
(D) Rent of equipment or facilities;
(E) Indirect labor and contract
supervisory wages, including basic
compensation, overtime pay, vacation
and holiday pay, sick leave pay (other
than payments pursuant to a wage
continuation plan under section 105(d)
as it existed prior to its repeal in 1983),
shift differential, payroll taxes, and

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contributions to a supplemental
unemployment benefits plan;
(F) Indirect materials and supplies;
(G) Noncapitalized tools and
equipment;
(H) Quality control and inspection;
(I) Taxes otherwise allowable as a
deduction under section 164, other than
state, local, and foreign income taxes, to
the extent attributable to labor,
materials, supplies, equipment, or
facilities;
(J) Depreciation, amortization, and
cost-recovery allowances reported for
the taxable year for financial purposes
on equipment and facilities to the extent
allowable as deductions under chapter 1
of the Internal Revenue Code;
(K) Cost depletion;
(L) Administrative costs other than
the cost of selling or any return on
capital;
(M) Compensation paid to officers
other than for incidental or occasional
services;
(N) Insurance, such as liability
insurance on machinery and equipment;
and
(O) Interest, as required under
paragraph (b)(2)(v) of this section.
(ii) Indirect costs not allocable to
exempt construction contracts. A
taxpayer allocating costs under this
paragraph (d)(2) is not required to
allocate the following costs to an
exempt construction contract reported
using the CCM—
(A) Marketing and selling expenses,
including bidding expenses;
(B) Advertising expenses;
(C) Other distribution expenses;
(D) General and administrative
expenses attributable to the performance
of services that benefit the taxpayer’s
activities as a whole (e.g., payroll
expenses, legal and accounting
expenses);
(E) Research and experimental
expenses (described in section 174 and
the regulations thereunder);
(F) Losses under section 165 and the
regulations thereunder;
(G) Percentage of depletion in excess
of cost depletion;
(H) Depreciation, amortization, and
cost recovery allowances on equipment
and facilities that have been placed in
service but are temporarily idle (for this
purpose, an asset is not considered to be
temporarily idle on non-working days,
and an asset used in construction is
considered to be idle when it is neither
en route to nor located at a job-site), and
depreciation, amortization and cost
recovery allowances under chapter 1 of
the Internal Revenue Code in excess of
depreciation, amortization, and cost
recovery allowances reported by the
taxpayer in the taxpayer’s financial
reports;

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2239

(I) Income taxes attributable to income
received from long-term contracts;
(J) Contributions paid to or under a
stock bonus, pension, profit-sharing, or
annuity plan or other plan deferring the
receipt of compensation whether or not
the plan qualifies under section 401(a),
and other employee benefit expenses
paid or accrued on behalf of labor, to the
extent the contributions or expenses are
otherwise allowable as deductions
under chapter 1 of the Internal Revenue
Code. Other employee benefit expenses
include (but are not limited to):
Worker’s compensation; amounts
deductible or for whose payment
reduction in earnings and profits is
allowed under section 404A and the
regulations thereunder; payments
pursuant to a wage continuation plan
under section 105(d) as it existed prior
to its repeal in 1983; amounts includible
in the gross income of employees under
a method or arrangement of employer
contributions or compensation which
has the effect of a stock bonus, pension,
profit-sharing, or annuity plan, or other
plan deferring the receipt of
compensation or providing deferred
benefits; premiums on life and health
insurance; and miscellaneous benefits
provided for employees such as safety,
medical treatment, recreational and
eating facilities, membership dues, etc.;
(K) Cost attributable to strikes, rework
labor, scrap and spoilage; and
(L) Compensation paid to officers
attributable to the performance of
services that benefit the taxpayer’s
activities as a whole.
(3) Large homebuilders. A taxpayer
must capitalize the costs of home
construction contracts under section
263A and the regulations thereunder,
unless the contract will be completed
within two years of the contract
commencement date and the taxpayer
satisfies the $10,000,000 gross receipts
test described in § 1.460–3(b)(3).
(e) Cost allocation rules for contracts
subject to the PCCM. A taxpayer must
use the cost allocation rules described
in paragraph (b) of this section to
determine the costs allocable to the
entire qualified ship contract or
residential construction contract
accounted for using the PCCM and may
not use the simplified cost-to-cost
method described in paragraph (c) of
this section.
(f) Special rules applicable to costs
allocated under this section—(1)
Nondeductible costs. A taxpayer may
not allocate any otherwise allocable
contract cost to a long-term contract if
any section of the Internal Revenue
Code disallows a deduction for that type
of payment or expenditure (e.g., an
illegal bribe described in section 162(c)).

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(2) Costs incurred for non-long-term
contract activities. If a taxpayer
performs a non-long-term contract
activity, as defined in § 1.460–1(d)(2),
that is incident to or necessary for the
manufacture, building, installation, or
construction of the subject matter of one
or more of the taxpayer’s long-term
contracts, the taxpayer must allocate the
costs attributable to that activity to such
contract(s).
(g) Method of accounting. A taxpayer
that adopts or elects a cost allocation
method of accounting (or changes to
another cost allocation method of
accounting with the Commissioner’s
consent) must apply that method
consistently for all similarly classified
contracts, until the taxpayer obtains the
Commissioner’s consent under section
446(e) to change to another cost
allocation method. A taxpayer-initiated
change in cost allocation method will be
permitted only on a cut-off basis (i.e., for
contracts entered into on or after the
year of change) and thus, a section
481(a) adjustment will not be permitted
or required.
Par. 9. Section 1.460–6 is amended as
follows:
1. A sentence is added to the end of
paragraph (a)(2).
2. The third sentence of paragraph
(b)(1) is removed.
3. In the fourth sentence of paragraph
(b)(1), ‘‘Therefore, to the extent that the
percentage of completion method is
required to be used’’ is removed and
‘‘To the extent that the percentage of
completion method is required to be
used under § 1.460–1(g)’’ is added in its
place.
4. The first sentence of paragraph
(c)(1)(ii)(A) is revised.
5. In the first sentence of paragraph
(c)(1)(ii)(B), the language ‘‘no later than
the year’’ is removed and ‘‘in the year’’
is added in its place and ‘‘§ 1.451–
3(b)(2)’’ is removed and ‘‘§ 1.460–
1(c)(3)’’ is added in its place.
6. The last two sentences of paragraph
(c)(1)(ii)(B) are removed.
7. In the last sentence of paragraph
(c)(1)(ii)(C)(2), the language ‘‘§ 5h.6’’ is
removed and ‘‘§ 301.9100–8 of this
chapter’’ is added in its place.
8. In the fourth sentence of paragraph
(c)(2)(v)(A), the language ‘‘similarly’’ is
removed.
9. The first, second, fifth, and sixth
sentences of paragraph (c)(2)(v)(A) are
removed.
10. In the first sentence of paragraph
(c)(2)(vi)(B), the language
‘‘§ 1.453(b)(2)(ii), (iii), (iv), and § 1.451–
3(d)(2), (3), and (4)’’ is removed and
‘‘§ 1.460–4(b)(4)(i)’’ is added in its place.
11. In the second sentence of
paragraph (c)(2)(vi)(B), the language

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‘‘the percentage of completion method
and’’ is removed.
12. In the third sentence of paragraph
(c)(2)(vi)(B), the language ‘‘, for
purposes of both the percentage of
completion method and the look-back
method’’ is removed.
13. In the fourth sentence of
paragraph (c)(2)(vi)(B), the language
‘‘Similarly, a’’ is removed and ‘‘A’’ is
added in its place.
14. In the first sentence of paragraph
(c)(2)(vi)(C), the language ‘‘§ 1.451–3(e)’’
is removed and ‘‘§ 1.460–1(e)’’ is added
in its place.
15. Paragraph (c)(4)(iv) is removed.
16. In the first sentence of paragraph
(d)(4)(ii)(C), the language ‘‘within the
meaning of section 1504(a)’’ is removed
and ‘‘, as defined in § 1.1502–1(h)’’ is
added in its place.
17. In the fourth sentence of
paragraph (e)(2), the language ‘‘within
the meaning of section 1504(a)’’ is
removed and ‘‘, as defined in § 1.1502–
1(h)’’ is added in its place.
18. In the first sentence of paragraph
(f)(1), the language ‘‘or to be refunded’’
is removed and ‘‘from, or payable to, a
taxpayer’’ is added in its place.
19. In the first sentence of paragraph
(f)(1), the language ‘‘and reported’’ is
removed.
20. In the second sentence of
paragraph (f)(1), the language ‘‘and
Form 8697 is filed by’’ is removed.
21. In the second sentence of
paragraph (f)(2)(i), the language ‘‘fails to
file Form 8697 with respect to interest
required to be paid or that’’ is removed.
22. In the second sentence of
paragraph (f)(2)(i), the language ‘‘a
penalty for failing to file Form 8697’’ is
removed and ‘‘an underpayment penalty
under section 6651, and the taxpayer
also is liable for underpayment interest
under section 6601’’ is added in its
place.
23. In the third sentence of paragraph
(f)(2)(i), the language ‘‘penalty’’ is
removed and ‘‘subtitle F’’ is added in its
place.
24. In the fourth sentence of
paragraph (f)(2)(i), the language ‘‘or a tax
refund’’ is added after ‘‘liability’’.
25. In the first sentence of paragraph
(f)(2)(ii), the language ‘‘refunded’’ is
removed and ‘‘payable’’ is added in its
place.
26. Paragraph (f)(3) is added.
The revisions and additions read as
follows:
§ 1.460–6

Look-back method.

(a) * * *
(2) * * * Paragraph (j) of this section
provides guidance concerning the
election not to apply the look-back
method in de minimis cases.
*
*
*
*
*

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(c) * * * (1) * * *
(ii) * * * (A) In general. Except as
otherwise provided in section 460(b)(6)
(see § 1.460–6(j) for method of electing)
or § 1.460–6(e), a taxpayer must apply
the look-back method to a long-term
contract in the completion year and in
any post-completion year for which the
taxpayer must adjust total contract price
or total allocable contract costs, or both,
under the PCM. * * *
*
*
*
*
*
(f) * * *
(3) Statute of limitations and
compounding of interest on look-back
interest. For guidance on the statute of
limitations applicable to the assessment
and collection of look-back interest
owed by a taxpayer, see sections 6501
and 6502. A taxpayer’s claim for credit
or refund of look-back interest
previously paid by or collected from a
taxpayer is a claim for credit or refund
of an overpayment of tax and is subject
to the statute of limitations provided in
section 6511. A taxpayer’s claim for
look-back interest (or interest payable
on look-back interest) that is not
attributable to an amount previously
paid by or collected from a taxpayer is
a general, non-tax claim against the
federal government. For guidance on the
statute of limitations that applies to
general, non-tax claims against the
federal government, see 28 U.S.C.
sections 2401 and 2501. For guidance
applicable to the compounding of
interest when the look-back interest is
not paid, see sections 6601 to 6622.
*
*
*
*
*
§§ 1.460–7 and 1.460–8

[Removed]

Par. 10. Sections 1.460–7 and 1.460–
8 are removed.
§ 1.471–10

[Amended]

Par. 11. Section 1.471–10 is amended
by removing the language ‘‘§ 1.451–3’’
and adding ‘‘§ 1.460–2’’ in its place.
PART 602—OMB CONTROL NUMBERS
UNDER THE PAPERWORK
REDUCTION ACT
Par. 12. The authority citation for part
602 continues to read as follows:
Authority: 26 U.S.C. 7805.

Par. 13. In § 602.101, paragraph (b) is
amended by:
1. Removing the entry for ‘‘1.451–3’’.
2. The following entries are added in
numerical order to the table:
§ 602.101

*

OMB Control numbers.

*
*
(b) * * *

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Federal Register / Vol. 66, No. 8 / Thursday, January 11, 2001 / Rules and Regulations
CFR part or section where
identified and described
*
*
*
1.460–1 .................................
*

*

*

Current OMB
control No.
*

*
1545–1650

*

*

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
Approved: December 20, 2000.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury.
[FR Doc. 01–6 Filed 1–10–01; 8:45 am]
BILLING CODE 4830–01–U

DEPARTMENT OF THE TREASURY
Internal Revenue Service (IRS)
26 CFR Parts 1 and 602
[TD 8933]
RIN 1545–AX33

Qualified Transportation Fringe
Benefits
AGENCY: Internal Revenue Service (IRS),
Treasury.
ACTION: Final regulation.

This document contains final
regulations relating to qualified
transportation fringe benefits. These
final regulations provide rules to ensure
that transportation benefits provided to
employees are excludable from gross
income. These final regulations reflect
changes to the law made by the Energy
Policy Act of 1992, the Taxpayer Relief
Act of 1997, and the Transportation
Equity Act for the 21st Century. These
final regulations affect employers that
offer qualified transportation fringes and
employees who receive these benefits.
DATES: Effective Date: These regulations
are effective January 11, 2001.
Applicability Date: For dates of
applicability, see § 1.132–9(b), Q/A–25.
FOR FURTHER INFORMATION CONTACT: John
Richards, (202) 622–6040 (not a toll-free
number).
SUPPLEMENTARY INFORMATION:
SUMMARY:

Paperwork Reduction Act
The collection of information
contained in these final regulations has
been reviewed and approved by the
Office of Management and Budget in
accordance with the Paperwork
Reduction Act of 1995 (44 U.S.C. 3507)
under control number 1545–1676.
Responses to this collection of
information are mandatory to obtain the
benefit described under section 132(f).

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An agency may not conduct or
sponsor, and a person is not required to
respond to, a collection of information
unless it displays a valid control
number assigned by the Office of
Management and Budget.
The estimated average annual
recordkeeping burden per recordkeeper
is 26.5 hours. The estimated annual
reporting burden per respondent is .8
hours.
Comments concerning the accuracy of
this burden estimate and suggestions for
reducing this burden should be sent to
the Internal Revenue Service, Attn: IRS
Reports Clearance Officer,
W:CAR:MP:FP:S:O, Washington, DC
20224, and to the Office of Management
and Budget, Attn: Desk Officer for the
Department of the Treasury, Office of
Information and Regulatory Affairs,
Washington, DC 20503.
Books or records relating to a
collection of information must be
retained as long as their contents might
become material in the administration
of any internal revenue law. Generally,
tax returns and tax return information
are confidential, as required by 26
U.S.C. 6103.
Background
This document contains amendments
to 26 CFR part 1 (Income Tax
Regulations). On January 27, 2000, a
proposed regulation (REG–113572–99)
relating to qualified transportation
fringes was published in the Federal
Register (65 FR 4388). A public hearing
was held on June 1, 2000. Written or
electronic comments responding to the
notice of proposed rulemaking were
received. After consideration of all the
comments, the proposed regulations are
adopted as amended by this Treasury
decision. The revisions are discussed
below.
Explanation of Provisions and
Summary of Comments
In general, comments received on the
proposed regulations were favorable
and, accordingly, the final regulations
retain the general structure of the
proposed regulations, including the
question and answer format and a
variety of examples illustrating the
substance of the final regulations.
However, commentators made a number
of specific recommendations for
modifications and clarifications of the
regulations. In response to these
comments, the final regulations
incorporate the modifications and
clarifications described below.

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2241

A. Whether Vouchers are Readily
Available
Section 132(f)(3) provides that
qualified transportation fringes include
cash reimbursement for transit passes
‘‘only if a voucher or similar item which
may be exchanged only for a transit pass
is not readily available for direct
distribution by the employer to the
employee.’’ Thus, if vouchers are
readily available, the employer must use
vouchers and cash reimbursement of a
mass transit expense would not be a
qualified transportation fringe.
Most of the comments received
addressed the issue of whether vouchers
are ‘‘readily available.’’ Commentators
representing employers generally
favored rules permitting cash
reimbursement. Commentators
representing transit operators and
voucher providers generally favored
rules not permitting cash
reimbursement. The following discusses
three issues raised by commentators:
first, whether the proposed regulations’
1 percent safe harbor should be
retained; second, whether internal
administrative costs should be
considered in applying the 1 percent
test; and third, whether other
nonfinancial restrictions should be
considered in determining whether
vouchers are readily available.
1. The 1 Percent Safe Harbor
Under Notice 94–3, 1994–1 C.B. 327,
and the proposed regulations, a voucher
is readily available if an employer can
obtain it on terms no less favorable than
those available to an individual
employee and without incurring a
significant administrative cost. Under
the proposed regulations, administrative
costs relate only to fees paid to fare
media providers, and the determination
of whether obtaining a voucher would
result in a significant administrative
cost is made with respect to each transit
system voucher. The proposed
regulations provide a rule under which
administrative costs are treated as
significant if the average monthly
administrative costs incurred by the
employer for a voucher (disregarding
delivery charges imposed by the fare
media provider to the extent not in
excess of $15 per order) are more than
1 percent of the average monthly value
of the vouchers for a system.
Commentators, in particular those
representing fare media providers and
transit operators, suggested that the fare
media provider fee percentage causing
vouchers to not be readily available
should be raised because many fare
media providers charge fees in excess of
the 1 percent limit and, thus, under this

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PsN: 11JAR1