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Accounting for Long-Term Contracts (Portfolio 575)

Product Code: TPOR41
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Accounting for Long-Term Contracts, written by James E. Connor, J.D., Annette B. Smith, CPA, and Christine D. Turgeon, CPA, of PricewaterhouseCoopers, LLP, provides taxpayers with guidance in applying the long-term contract accounting methods. The Internal Revenue Code provides a special set of tax accounting rules for those taxpayers performing long-term contracts; these rules are contained in §460 and the regulations thereunder.

The initial question in working with these rules is their scope. A long-term contract is generally defined as a contract for the construction, installation, building, or manufacturing of property that begins in one year and is completed in a later tax year. Manufacturing contracts are treated as long-term contracts only if (1) they involve the manufacture of unique items not carried in finished goods inventory or (2) the manufacturing of each item produced pursuant to the contract normally takes longer than 12 months.

The Portfolio discusses the definition of a long-term contract in detail.  Long-term contracts generally must be accounted for using the percentage of completion (PCM) method, but in some situations may be accounted for under the completion capitalized cost method (PCCM) or the completed contract method (CCM) instead. The PCM and PCCM contain a look-back rule that requires a hypothetical recomputation of estimated contract costs and income. Taxpayers who enter into construction and/or manufacturing contracts will find this Portfolio particularly useful for deciding the extent to which the long-term contract rules apply and applying these complex rules, including the look-back rules.

Accounting for Long-Term Contracts allows you to benefit from:

  • Hundreds of hours of original research on specific tax planning topics from leading practitioners in this area.
  • Invaluable practice documents including tables, charts and lists.
  • Plain-English guidance from world-class experts.
  • Real-world and in-depth analysis that lets you explore various options.
  • Time-saving access to relevant sections of tax laws, regulations, court cases, IRS documents and more.
  • Alternative approaches to both common and unique tax scenarios.

This Portfolio is part of the U.S. Income Portfolios Library, a comprehensive series that includes more than 200 Portfolios, which cover every federal tax topic with expert, in-depth analysis, and offer commentary on a wide range of federal taxation topics, including Compensation Planning, Deductions and Credits, Partnerships and Corporations, Special Pass-Through Entities, Corporate Reorganizations, Real Estate, Procedure and Administration, and more.

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Detailed Analysis

I. Introduction

A. Overview and General Rules

B. How to Use this Portfolio

II. Is the Contract a "Long-Term Contract"?

A. In General

B. Construction Contracts

C. Manufacturing Contracts

1. In General

2. Unique Items

a. General Definition of "Unique Item"

b. Safe Harbors for Rebutting Unique Item Status

(1) Short Production Period

(2) Customized Item

(3) Inventoried Item

3. More Than 12 Months to Complete

III. If the Contract Is a Long-Term Contract, What Type of Contract Is It?

Introductory Material

A. General Long-Term Contracts

1. In General

2. Relevant Information for General Long-Term Contracts

B. Construction Contracts Performed by Small Contractors

1. In General

2. The Criteria

3. How to Determine Gross Receipts

4. Relevant Information for Construction Contracts Performed by Small Contractors

C. Home Construction Contracts

1. In General

2. Relevant Information for Home Construction Contracts

D. Residential Construction Contracts

1. In General

2. Relevant Information for Residential Construction Contracts

E. Qualified Ship Contracts

1. In General

2. Relevant Information for Qualified Ship Contracts

IV. Other Rules for Determining the Scope of the Long-Term Contract Rules

A. Severing and Aggregating Contracts

B. Non-Long-Term Contract Activities Required to Be Accounted for Under Long-Term Contract Rules

1. Same Party Performing Non-Long-Term Contract Activities and Long-Term-Contract Activities

2. Performance of Non-Long-Term Contract Activities for Related Party That Is Performing Long-Term Contract Activities

V. Long-Term Contract Accounting Methods

A. General Rules

B. Percentage of Completion Method

1. In General

2. The Percentage of Completion Formula

a. In General

b. Terms Used in the Formula

(1) Total Contract Price

(2) Cumulative Allocable Contract Costs (I.e., Contract Costs Incurred by Year-End)

(3) Estimated Total Contract Costs

3. The 10-Percent Method

4. Post-Completion Year Income and Costs

5. Deferred Intercompany Transaction Rules

C. Percentage of Completion Capitalized Cost Method

D. Exempt Contract Methods

1. In General

2. Completed Contract Method

3. Exempt-Contract Percentage-of-Completion Method

E. Alternative Minimum Tax Rules

VI. Look-Back Rule

A. Overview

1. Conceptual Discussion of Look-Back Rule

2. When the Look-Back Rules Apply, and When They Do Not

B. Mechanics of the Look-Back Rule

1. The Steps for Application of the Look-Back Rule in the Year of Completion

a. Step 1 - Redetermination of Taxable Income for Prior Years

b. Step 2 - Computation of Change of Tax Liability for Prior Years

(1) Actual Method

(2) Simplified Marginal Impact Method

c. Step 3 - Computation of Interest Due to or from the Government

2. Look-Back Calculation in Post-Completion Years

a. General Rules

b. Mechanics of Reapplication of Look-Back Rules After Completion

c. Delayed Reapplication Method

d. Elective De Minimis Rule for Reducing Reapplications of Look-Back Rule After Completion

C. Reporting Look-Back Interest

D. Example of Look-Back Calculation

E. Transfer or Termination of Contract Prior to Completion

VII. Long-Term Contract Costing Rules

A. Overview

B. Cost Allocation Rules for Contracts Subject to the § 460 Percentage of Completion Method (PCM) or the Percentage of Completion Capitalized Cost Method (PCCM)

1. In General

2. Section 460 Allocable Contract Costs

a. In General

b. Costs Treated as Contract Costs

(1) Direct Materials

(2) Components and Subassemblies

(3) Labor-Related Costs

(4) Equipment and Facilities Costs

(5) General and Administrative Costs

(6) Bidding Costs

(7) Research and Experimental Costs

(8) Taxes

(9) Miscellaneous Costs

(10) Interest

(11) Additional Contract Costs of Cost-Plus and Federal Long-Term Contracts

3. Non-Contract Costs

4. Methods of Allocating Indirect Costs

a. In General

b. Allocation of Service Costs

5. Simplified Cost-to-Cost Method

C. Cost Allocation Rules for Exempt Contracts

1. Contract Costing Rules for Contracts Using the Completed Contract Method (CCM) (Other Than Large Homebuilders)

2. Contract Costing Rules for Contracts of Large Homebuilders

3. Contract Costing Rules for Other Exempt Contract Methods of Accounting

VIII. Special Rules

A. Terminated Contracts

B. Mid-Contract Change in Taxpayer

1. General Rule

2. Step-in-the-Shoes Transactions

a. Effect on Old Taxpayer

b. Effect on New Taxpayer

c. Example

d. Look Back Rule

3. Constructive Completion Transactions

a. Effect on Old Taxpayer

b. Effect on New Taxpayer

c. Example

d. Look-Back

4. Special Partnership Rules

a. In General

b. Contribution of a Contract to a Partnership

c. Built-In Income and Loss

d. Transfer of a Partnership Interest

e. Adjustments to the Basis of Partnership Property

f. Closing of the Books

g. Distribution of a Contract by a Partnership to a Partner

C. Year of Completion

1. In General

2. Date of Completion

IX. Accounting Method Changes

A. In General

B. Special Rules Applicable to § 460 Method Changes

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Working Papers

Table of Worksheets

Worksheet 1 Sample Form 8697

Worksheet 2 Sample Form 3115, Application for Change in Accounting Method filled in, with Attachments

Worksheet 3 Sample Election Statements - Long-Term Contractors

Worksheet 4 Statement Notifying the IRS that a Taxpayer Has Severed or Aggregated Contracts

Worksheet 5 Conference Committee Report for Long-Term Contract Provisions in TRA 1986

Worksheet 6 Conference Committee Report for Long-Term Contract Provisions in 1987 Act

Worksheet 7 Conference Committee Report for Long-Term Contract Provisions in 1988 Act

Worksheet 8 Conference Committee Report for Long-Term Contract Provisions in 1989 Act

Worksheet 9 Conference Committee Report for Simplified Look-Back Elective Provision in 1997 Act

Worksheet 10 Preamble to T.D. 8929, Comprehensive Long-Term Contract Regulations Issued January 11, 2001

Worksheet 11 Preamble to T.D. 8315, Comprehensive Look-Back Regulations Issued October 12, 1990

Worksheet 12 Preamble to T.D. 8995, General Regulations on Mid-Contract Change of Taxpayer Issued May 14, 2002

Worksheet 13 Preamble to T.D. 9137, Mid-Contract Change of Taxpayer in Partnership Context Issued July 16, 2004

Worksheet 14 Notice 88-99, Secs. VIII-End

Worksheet 15 IRS Coordinated Issue Papers Related to Long-Term Contract Issues

Worksheet 16 [Reserved]

Worksheet 17 List of Examples of Costs Treated as Allocable Contract Costs for Taxpayers Using the Percentage of Completion Method Under Section 460 (and Not Using the Simplified Cost to Cost Method)

Worksheet 18 List of Examples of Costs Required to Be Treated as Contract Costs for Large Homebuilders (the Uniform Capitalization Rules)

Worksheet 19 List of Examples of Costs Allocable to Long-Term Contracts Under the Completed Contract Method (for Taxpayers Who Do Not Use the UCR to Determine Contract Costs)

Worksheet 20 List of Available Elections for Long-Term Contractors

Worksheet 21 Pre-TRA 1986 History of the Long-Term Contract Costing Rules

Worksheet 22 Pre-Final Section 460 Regulations Guidance (Notice 89-15)

Bibliography

OFFICIAL

Statutes:

Treasury Regulations:

Legislative history:

Treasury Rulings:

Cases:

UNOFFICIAL

Periodicals:

1986

1990

1991

1995

1996

1997

1999

2002

2003

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James E. Connor
James E. Connor, B.A., Cornell University; J.D., University of Pennsylvania Law School; LL.M in Taxation, Georgetown University Law Center; co-leader of Federal Tax Services group of Washington National Tax Services office of PricewaterhouseCoopers LLP; adjunct professor, Georgetown University Law Center (LL.M. program), 1985-1990; formerly of Office of Chief Counsel, Internal Revenue Service, 1977-1985.
Annette B. Smith
Annette B. Smith, B.S.B.A., University of Cincinnati; M.S.B.A. – Taxation, University of Cincinnati; partner, Washington National Tax Services office of PricewaterhouseCoopers LLP; formerly of Office of Tax Legislative Counsel, U.S. Department of Treasury (1995-2000); served as Deputy to the Tax Legislative Counsel (1999-2000) and Senior Tax Law Specialist specializing in accounting methods and inventories (1995-1998); member, American Institute of Certified Public Accountants.
Christine M. Turgeon
Christine M. Turgeon, B.B.A., Baylor University; B.S. in Taxation, American University; partner, Washington National Tax Services office of PricewaterhouseCoopers LLP; formerly of Office of Tax Legislative Counsel, U.S. Department of the Treasury (1998-2002), served as Senior Tax Law Specialist specializing in accounting methods and inventories; member, American Institute of Certified Public Accountants Technical Resource Panel on Accounting Methods. 
A. Duane Webber
A. Duane Webber, Kansas State University (B.A., B.S. 1981); Georgetown University (J.D. 1984); Member, Section of Taxation (Court Procedure Committee) and Section of Litigation of the American Bar Association; Member, Taxation Section of the Federal Bar Association; Member, J. Edgar