---
kind: "range"
citation: "26 C.F.R. §§ 1.460-2–1.460-5"
title: "26"
from: "1.460-2"
to: "1.460-5"
count: 4
url: "https://uscodex.org/cfr/26/1.460-2..1.460-5"
---

# §1.460-2. Long-term manufacturing contracts.

- (a) **In general.** [Section 460](/cfr/26/460.md) generally requires a taxpayer to determine the income from a long-term manufacturing contract using the percentage-of-completion method described in [§ 1.460-4(b)](/cfr/26/1.460-4.md?p=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)](#b), a taxpayer must consider the activities performed on its behalf by a subcontractor.
  - (2) **Safe harbors.** Notwithstanding [paragraph (b)(1)](#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)](#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:
    - (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 first unit of the item must be allocated to that 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](/cfr/26/1.263A-12.md), 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](/cfr/26/1.460-5.md) 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](/cfr/26/460.md) (e.g., independent research and development expenses (as defined in [§ 1.460-1(b)(9)](/cfr/26/1.460-1.md?p=b-9)) and marketing expenses). Moreover, the time normally required to design and manufacture the first unit of an item for which the taxpayer intends to produce multiple units generally does not 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)](/cfr/26/1.460-1.md?p=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)](/cfr/26/1.460-1.md?p=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-of-completion/capitalized-cost method (PCCM) of accounting described in [§ 1.460-4(e)](/cfr/26/1.460-4.md?p=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)](/cfr/26/1.460-1.md?p=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:

# §1.460-3. Long-term construction contracts.

- (a) **In general.** [Section 460](/cfr/26/460.md) generally requires a taxpayer to determine the income from a long-term construction contract using the percentage-of-completion method described in [§ 1.460-4(b)](/cfr/26/1.460-4.md?p=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)](/cfr/26/1.263A-8.md?p=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)](/cfr/26/1.460-5.md?p=b) or [(c)](/cfr/26/1.460-5.md?p=c) does not apply to any long-term construction contract described in this [paragraph (b)](#b) (exempt construction contract). Exempt construction contract means any—
    - (i) Home construction contract; and
    - (ii) Other construction contract, entered into after December 31, 2017, in a taxable year ending after December 31, 2017, by a taxpayer, other than a tax shelter prohibited from using the cash receipts and disbursements method of accounting (cash method) under [section 448(a)(3)](/cfr/26/448.md?p=a-3), who estimates at the time such contract is entered into that such contract will be completed within the 2-year period beginning on the contract commencement date, and who meets the gross receipts test described in [paragraph (b)(3)](#b-3) of this section for the taxable year in which such contract is entered into.
  - (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)](/cfr/26/168.md?p=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) **Gross receipts test—**
    - (i) **In general.** A taxpayer, other than a tax shelter prohibited from using the cash method under [section 448(a)(3)](/cfr/26/448.md?p=a-3), meets the gross receipts test of this [paragraph (b)(3)](#b-3) if it meets the gross receipts test of [section 448(c)](/cfr/26/448.md?p=c) and [§ 1.448-2(c)(2)](/cfr/26/1.448-2.md?p=c-2). This gross receipts test applies even if the taxpayer is not otherwise subject to [section 448(a)](/cfr/26/448.md?p=a).
    - (ii) **Application of gross receipts test—**
      - (A) **In general.** In the case of any taxpayer that is not a corporation or a partnership, and except as provided in paragraphs [(b)(3)(ii)(B)](#b-3-ii-B) and [(C)](#b-3-ii-C) of this section, the gross receipts test of [section 448(c)](/cfr/26/448.md?p=c) and the accompanying regulations are applied in the same manner as if each trade or business of such taxpayer were a corporation or partnership.
      - (B) **Gross receipts of individuals, etc.** Except when the aggregation rules of [section 448(c)(2)](/cfr/26/448.md?p=c-2) apply, the gross receipts of a taxpayer other than a corporation or partnership are the amount derived from all trades or businesses of such taxpayer. Amounts not related to a trade or business are excluded from the gross receipts of the taxpayer. For example, an individual taxpayer's gross receipts do not include inherently personal amounts, such as personal injury awards or settlements with respect to an injury of the individual taxpayer, disability benefits, Social Security benefits received by the taxpayer during the taxable year, and wages received as an employee that are reported on Form W-2.
      - (C) **Partners and S corporation shareholders.** Except when the aggregation rules of [section 448(c)(2)](/cfr/26/448.md?p=c-2) apply, each partner in a partnership includes a share of partnership gross receipts in proportion to such partner's distributive share (as determined under [section 704](/cfr/26/704.md)) of items of gross income that were taken into account by the partnership under [section 703](/cfr/26/703.md). Similarly, a shareholder includes the pro rata share of S corporation gross receipts taken into account by the S corporation under [section 1363(b)](/cfr/26/1363.md?p=b).
      - (D) **Examples.** The operation of this [paragraph (b)(3)](#b-3) is illustrated by the following examples:

        (1) Example 1. Taxpayer A is an individual who operates two separate and distinct trades or business that are reported on Schedule C, Profit or Loss from Business, of A's Federal income tax return. For 2020, one trade or business has annual average gross receipts of $5 million, and the other trade or business has average annual gross receipts of $35 million. Under [paragraph (b)(3)(ii)(B)](#b-3-ii-B) of this section, for 2020, neither of A's trades or businesses meets the gross receipts test of [paragraph (b)(3)](#b-3) of this section ($5 million + $35 million = $40 million, which is greater than the inflation-adjusted gross receipts test amount for 2020, which is $26 million).

        (2) Example 2. Taxpayer B is an individual who operates three separate and distinct trades or business that are reported on Schedule C of B's Federal income tax return. For 2020, Business X is a retail store with average annual gross receipts of $15 million, Business Y is a dance studio with average annual gross receipts of $6 million, and Business Z is a car repair shop with average annual gross receipts of $12 million. Under [paragraph (b)(3)(ii)(B)](#b-3-ii-B) of this section, B's gross receipts are the combined amount derived from all three of B's trades or businesses. Therefore, for 2020, X, Y and Z do not meet the gross receipts test of [paragraph (b)(3)(i)](#b-3-i) of this section ($15 million + $6 million + $12 million = $33 million, which is greater than the inflation-adjusted gross receipts test amount for 2020, which is $26 million).

    - (iii) **Method of accounting.** A change in the method of accounting used for exempt construction contracts described in [paragraph (b)(1)(ii)](#b-1-ii) of this section is a change in method of accounting under [section 446](/cfr/26/446.md) and the accompanying regulations. For rules distinguishing a change in method from adoption of a method, see [§ 1.460-1(f)(3)](/cfr/26/1.460-1.md?p=f-3). A taxpayer changing its method of accounting must obtain the consent of the Commissioner in accordance with [§ 1.446-1(e)(3)](/cfr/26/1.446-1.md?p=e-3). For rules relating to the clear reflection of income and the pattern of consistent treatment of an item, see [section 446](/cfr/26/446.md) and [§ 1.446-1](/cfr/26/1.446-1.md). A change in method of accounting shall be implemented pursuant to the applicable administrative procedures to obtain the consent of the Commissioner to change a method of accounting under [section 446(e)](/cfr/26/446.md?p=e) as published in the Internal Revenue Bulletin (IRB) (see Revenue Procedure 2015-13 (2015-5 IRB 419) (or successor) (see [§ 601.601(d)(2)](/cfr/26/601.601.md?p=d-2) of this chapter)). A taxpayer that uses the percentage of completion method for exempt contracts described in [paragraph (b)(1)(ii)](#b-1-ii) of this section that wants to change to another exempt contract method is to use the applicable administrative procedures to obtain the automatic consent of the Commissioner to change such method under [section 446(e)](/cfr/26/446.md?p=e) as published in the IRB. A taxpayer-initiated change in method of accounting will be permitted only on a cut-off basis, and thus, a [section 481(a)](/cfr/26/481.md?p=a) adjustment will not be permitted or required. See [§ 1.460-4(g)](/cfr/26/1.460-4.md?p=g).
- (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/capitalized-cost method (PCCM) of accounting described in [§ 1.460-4(e)](/cfr/26/1.460-4.md?p=e). A residential construction contract is a home construction contract, as defined in [paragraph (b)(2)](#b-2) of this section, except that the building or buildings being constructed contain more than 4 dwelling units.
- (d) **Applicability Dates.** Paragraphs [(b)(1)(ii)](#b-1-ii) and (b)(3) of this section apply, for contracts entered into in taxable years beginning on or after January 5, 2021. However, for contracts entered into after December 31, 2017, in a taxable year ending after December 31, 2017, and before January 5, 2021, a taxpayer may apply the paragraphs described in the first sentence of this [paragraph (d)](#d), provided that the taxpayer follows all the applicable rules contained in the regulations under [section 460](/cfr/26/460.md) for such taxable year and all subsequent taxable years.

# §1.460-4. Methods of accounting for long-term contracts.

- (a) **Overview.** This section prescribes permissible methods of accounting for long-term contracts. [Paragraph (b)](#b) of this section describes the percentage-of-completion method under [section 460(b)](/cfr/26/460.md?p=b) (PCM) that a taxpayer generally must use to determine the income from a long-term contract. [Paragraph (c)](#c) of this section lists permissible methods of accounting for exempt construction contracts described in [§ 1.460-3(b)(1)](/cfr/26/1.460-3.md?p=b-1) and describes the exempt-contract percentage-of-completion method (EPCM). [Paragraph (d)](#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)](#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)](/cfr/26/1.460-2.md?p=d) and residential construction contracts described in [§ 1.460-3(c)](/cfr/26/1.460-3.md?p=c). [Paragraph (f)](#f) of this section provides rules for determining the alternative minimum taxable income (AMTI) from long-term contracts that are not exempted under [section 56](/cfr/26/56.md). [Paragraph (g)](#g) of this section provides rules concerning consistency in methods of accounting for long-term contracts. [Paragraph (h)](#h) of this section provides examples illustrating the principles of this section. [Paragraph (j)](#j) of this section provides rules for taxpayers that file consolidated tax returns. Finally, [paragraph (k)](#k) of this section provides rules relating to a mid-contract change in taxpayer of a contract accounted for using a long-term contract method of accounting.
- (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)](#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 current-year 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)](/cfr/26/1.460-1.md?p=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-year costs, see [paragraph (b)(5)(v)](#b-5-v) of this section. See [§ 1.460-6(c)(1)(ii)](/cfr/26/1.460-6.md?p=c-1-ii) for application of the look-back method as a result of adjustments to total contract price.
  - (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)](/cfr/26/1.460-6.md?p=c-1-ii) and [(2)(vi)](/cfr/26/1.460-6.md?p=c-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)](/cfr/26/1.460-1.md?p=e). For the purposes of this [paragraph (b)(4)(i)(B)](#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)](#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)](/cfr/26/1.460-1.md?p=d-2), if the activity is incident to or necessary 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)](/cfr/26/1.460-1.md?p=b-9)), or for bidding and proposal costs, under a federal or cost-plus long-term contract (as defined in [section 460(d)](/cfr/26/460.md?p=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)](/cfr/26/1.460-5.md?p=b) or [(c)](/cfr/26/1.460-5.md?p=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)](/cfr/26/1.460-1.md?p=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 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)](/cfr/26/1.460-1.md?p=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)](#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-contracting-year 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)](/cfr/26/1.460-6.md?p=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)](/cfr/26/460.md?p=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 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)](#b-5-iv) of this section.
    - (ii) **Election.** A taxpayer makes an election under this [paragraph (b)(6)](#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](/cfr/26/1.460-6.md) and to determine alternative minimum taxable income under [paragraph (f)](#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)](/cfr/26/1.460-5.md?p=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)](#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)](#b-7).
- (c) **Exempt contract methods—**
  - (1) **In general.** An exempt contract method means the method of accounting that a 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)](/cfr/26/460.md?p=a). Thus, an exempt contract method applies to exempt construction contracts, as defined in [§ 1.460-3(b)](/cfr/26/1.460-3.md?p=b); the non-PCM portion of a qualified ship contract, as defined in [§ 1.460-2(d)](/cfr/26/1.460-2.md?p=d); and the non-PCM portion of a residential construction contract, as defined in [§ 1.460-3(c)](/cfr/26/1.460-3.md?p=c). Permissible exempt contract methods include the PCM, the EPCM described in [paragraph (c)(2)](#c-2) of this section, the CCM described in [paragraph (d)](#d) of this section, or any other permissible method. See [section 446](/cfr/26/446.md).
  - (2) **Exempt-contract percentage-of-completion method—**
    - (i) **In general.** Similar to the PCM described in [paragraph (b)](#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)](#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)](#b-2-i) and (5) of this section, provided such method is used consistently and clearly reflects income. In addition, [paragraph (b)(3)](#b-3) of this section (regarding post-completion-year income), [paragraph (b)(6)](#b-6) of this section (regarding the 10-percent method) and [§ 1.460-6](/cfr/26/1.460-6.md) (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)](#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 [§ 1.460-1(b)(6)](/cfr/26/1.460-1.md?p=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)](#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)](/cfr/26/1.460-1.md?p=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)](/cfr/26/1.460-1.md?p=b-9)), or bidding and proposal costs, under a federal or cost-plus long-term contract (as defined in [section 460(d)](/cfr/26/460.md?p=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)](#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 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)](#d-4-i), [(ii)](#d-4-ii), or [(iii)](#d-4-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)](#c) of this section, for the remaining percentage of the contract. For residential construction contracts described in [§ 1.460-3(c)](/cfr/26/1.460-3.md?p=c), the applicable percentage is 70 percent, and the remaining percentage is 30 percent. For qualified ship contracts described in [§ 1.460-2(d)](/cfr/26/1.460-2.md?p=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)](/cfr/26/56.md?p=a-3), a taxpayer subject to the AMT 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)](/cfr/26/1.460-3.md?p=b-2). For AMTI purposes, the PCM must include any election under [paragraph (b)(6)](#b-6) of this section (concerning the 10-percent method) or under [§ 1.460-5(c)](/cfr/26/1.460-5.md?p=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)](/cfr/26/1.460-3.md?p=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)](#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)](/cfr/26/56.md?p=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)](#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)](#f-2) does not eliminate a taxpayer's obligation to comply with the requirements of [section 55](/cfr/26/55.md) 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](/cfr/26/56.md) to compute AMTI.
- (g) **Method of accounting.** A taxpayer that uses the PCM, EPCM, CCM, or 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)](/cfr/26/446.md?p=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)](/cfr/26/481.md?p=a) adjustment will not be permitted or required.
- (h) **Examples.** The following examples illustrate the rules of this section:
- (i) **Applicability date.** [Paragraph (f)(1)](#f-1) of this section applies to taxable years beginning on or after January 5, 2021. However, for a taxable year beginning after December 31, 2017, and before January 5, 2021, a taxpayer may apply the paragraph described in the first sentence of this [paragraph (i)](#i), provided that the taxpayer follows all the applicable rules contained in the regulations under [section 460](/cfr/26/460.md) for such taxable year and all subsequent taxable years.
- (j) **Consolidated groups and controlled groups—**
  - (1) **Intercompany transactions—**
    - (i) **In general.** [Section 1.1502-13](/cfr/26/1.1502-13.md) does not apply to the income, gain, deduction, or loss from an intercompany transaction between members of a consolidated group, and [section 267(f)](/cfr/26/267.md?p=f) does not apply to these items from an intercompany sale between members of a controlled group, to the extent—
      - (A) The transaction or sale directly or indirectly benefits, or is intended to benefit, another member's long-term contract with a nonmember;
      - (B) The selling member is required under [section 460](/cfr/26/460.md) to determine any part of its gross income from the transaction or sale under the percentage-of-completion method (PCM); and
      - (C) The member with the long-term contract is required under [section 460](/cfr/26/460.md) to determine any part of its gross income from the long-term contract under the PCM.
    - (ii) **Definitions and nomenclature.** The definitions and nomenclature under [§ 1.1502-13](/cfr/26/1.1502-13.md) and [§ 1.267(f)-1](/cfr/26/1.267..1.md) apply for purposes of this [paragraph (j)](#j).
  - (2) **Example.** The following example illustrates the principles of [paragraph (j)(1)](#j-1) of this section.
  - (3) **Effective dates—**
    - (i) **In general.** This [paragraph (j)](#j) applies with respect to transactions and sales occurring pursuant to contracts entered into in years beginning on or after July 12, 1995.
    - (ii) **Prior law.** For transactions and sales occurring pursuant to contracts entered into in years beginning before July 12, 1995, see the applicable regulations issued under sections [267(f)](/cfr/26/267.md?p=f) and [1502](/cfr/26/1502.md), including §§ [1.267(f)-1T](/cfr/26/1.267..1T.md), [1.267(f)-2T](/cfr/26/1.267..2T.md), and [1.1502-13(n)](/cfr/26/1.1502-13.md?p=n) (as contained in the [26 CFR part 1](/cfr/26/part1.md) edition revised as of April 1, 1995).
  - (4) **Consent to change method of accounting.** For transactions and sales to which this [paragraph (j)](#j) applies, the Commissioner's consent under [section 446(e)](/cfr/26/446.md?p=e) is hereby granted to the extent any changes in method of accounting are necessary solely to comply with this section, provided the changes are made in the first taxable year of the taxpayer to which the rules of this [paragraph (j)](#j) apply. Changes in method of accounting for these transactions are to be effected on a cut-off basis.
- (k) **Mid-contract change in taxpayer—**
  - (1) **In general.** The rules in this [paragraph (k)](#k) apply if prior to the completion of a long-term contract accounted for using a long-term contract method by a taxpayer (old taxpayer), there is a transaction that makes another taxpayer (new taxpayer) responsible for accounting for income from the same contract. For purposes of this [paragraph (k)](#k) and [§ 1.460-6(g)](/cfr/26/1.460-6.md?p=g), an old taxpayer also includes any old taxpayer(s) (e.g., predecessors) of the old taxpayer. In addition, a change in status from taxable to tax exempt or from domestic to foreign, or vice versa, will be considered a change in taxpayer. Finally, a contract will be treated as the same contract if the terms of the contract are not substantially changed in connection with the transaction, whether or not the customer agrees to release the old taxpayer from any or all of its obligations under the contract. The rules governing constructive completion transactions are provided in [paragraph (k)(2)](#k-2) of this section, while the rules governing step-in-the-shoes transactions are provided in [paragraph (k)(3)](#k-3) of this section. Special rules relating to the treatment of certain partnership transactions are provided in paragraphs [(k)(2)(iv)](#k-2-iv) and [(k)(3)(v)](#k-3-v) of this section. For application of the look-back method to mid-contract changes in taxpayers for contracts accounted for using the PCM, see [§ 1.460-6(g)](/cfr/26/1.460-6.md?p=g).
  - (2) **Constructive completion transactions—**
    - (i) **Scope.** The constructive completion rules in this [paragraph (k)(2)](#k-2) apply to transactions (constructive completion transactions) that result in a change in the taxpayer responsible for reporting income from a contract and that are not described in [paragraph (k)(3)(i)](#k-3-i) of this section. Constructive completion transactions generally include, for example, taxable sales under [section 1001](/cfr/26/1001.md) and deemed asset sales under [section 338](/cfr/26/338.md).
    - (ii) **Old taxpayer.** The old taxpayer is treated as completing the contract on the date of the transaction. The total contract price (or, gross contract price in the case of a long-term contract accounted for under the CCM) for the old taxpayer is the sum of any amounts realized from the transaction that are allocable to the contract and any amounts the old taxpayer has received or reasonably expects to receive under the contract. Total contract price (or gross contract price) is reduced by any amount paid by the old taxpayer to the new taxpayer, and by any transaction costs, that are allocable to the contract. Thus, the old taxpayer's allocable contract costs determined under [paragraph (b)(5)](#b-5) of this section do not include any consideration paid, or costs incurred, as a result of the transaction that are allocable to the contract. In the case of a transaction subject to section [338](/cfr/26/338.md) or [1060](/cfr/26/1060.md), the amount realized from the transaction allocable to the contract is determined by using the residual method under §§ [1.338-6](/cfr/26/1.338-6.md) and [1.338-7](/cfr/26/1.338-7.md).
    - (iii) **New taxpayer.** The new taxpayer is treated as entering into a new contract on the date of the transaction. The new taxpayer must evaluate whether the new contract should be classified as a long-term contract within the meaning of [§ 1.460-1(b)](/cfr/26/1.460-1.md?p=b) and account for the contract under a permissible method of accounting. For a new taxpayer who accounts for a contract using the PCM, the total contract price is any amount the new taxpayer reasonably expects to receive under the contract consistent with [paragraph (b)(4)](#b-4) of this section. Total contract price is reduced by the amount of any consideration paid by the new taxpayer as a result of the transaction, and by any transaction costs, that are allocable to the contract and is increased by the amount of any consideration received by the new taxpayer as a result of the transaction that is allocable to the contract. Similarly, the gross contract price for a contract accounted for using the CCM is all amounts the new taxpayer is entitled by law or contract to receive consistent with [paragraph (d)(3)](#d-3) of this section, adjusted for any consideration paid (or received) by the new taxpayer as a result of the transaction, and for any transaction costs, that are allocable to the contract. Thus, the new taxpayer's allocable contract costs determined under [paragraph (b)(5)](#b-5) of this section do not include any consideration paid, or costs incurred, as a result of the transaction that are allocable to the contract. In the case of a transaction subject to sections [338](/cfr/26/338.md) or [1060](/cfr/26/1060.md), the amount of consideration paid that is allocable to the contract is determined by using the residual method under §§ [1.338-6](/cfr/26/1.338-6.md) and [1.338-7](/cfr/26/1.338-7.md).
    - (iv) **Special rules relating to distributions of certain contracts by a partnership—**
      - (A) **In general.** The constructive completion rules of [paragraph (k)(2)](#k-2) of this section apply both to the distribution of a contract accounted for under a long-term contract method of accounting by a partnership to a partner and to the distribution of an interest in a partnership (lower-tier partnership) holding (either directly or through other partnerships) one or more contracts accounted for under a long-term contract method of accounting by another partnership (upper-tier partnership). Notwithstanding the previous sentence, the constructive completion rules of [paragraph (k)(2)](#k-2) of this section do not apply to a transfer by a partnership (transferor partnership) of all of its assets and liabilities to a second partnership (transferee partnership) in an exchange described in [section 721](/cfr/26/721.md), followed by a distribution of the interest in the transferee partnership in liquidation of the transferor partnership, under [§ 1.708-1(b)(4)](/cfr/26/1.708-1.md?p=b-4) (relating to terminations under [section 708(b)(1)(B)](/cfr/26/708.md?p=b-1-B)) or [§ 1.708-1(c)(3)(i)](/cfr/26/1.708-1.md?p=c-3-i) (relating to certain partnership mergers). If a partnership that holds a contract accounted for under a long-term contract method of accounting terminates under [section 708(b)(1)(A)](/cfr/26/708.md?p=b-1-A) because the number of its owners is reduced to one, the entire contract will be treated as being distributed from the partnership for purposes of the constructive completion rules, and the partnership must apply [paragraph (k)(2)](#k-2) of this section immediately prior to the transaction or transactions resulting in the termination of the partnership.
      - (B) **Old taxpayer.** The partnership that distributes the contract is treated as the old taxpayer for purposes of [paragraph (k)(2)(ii)](#k-2-ii) of this section. For purposes of determining the total contract price (or gross contract price) under [paragraph (k)(2)(ii)](#k-2-ii) of this section, the fair market value of the contract is treated as the amount realized from the transaction. For purposes of determining each partner's distributive share of partnership items, any income or loss resulting from the constructive completion must be allocated among the partners of the old taxpayer as though the partnership closed its books on the date of the distribution.
      - (C) **New taxpayer.** The partner receiving the distributed contract is treated as the new taxpayer for purposes of [paragraph (k)(2)(iii)](#k-2-iii) of this section. For purposes of determining the total contract price (or gross contract price) under [paragraph (k)(2)(iii)](#k-2-iii) of this section, the new taxpayer's basis in the contract (including the uncompleted property, if applicable) after the distribution (as determined under [section 732](/cfr/26/732.md)) is treated as consideration paid by the new taxpayer that is allocable to the contract. Thus, the total contract price (or gross contract price) of the new contract is reduced by the partner's basis in the contract (including the uncompleted property, if applicable) immediately after the distribution.
      - (D) **Basis rules.** For purposes of determining the new taxpayer's basis in the contract (including the uncompleted property, if applicable) under [section 732](/cfr/26/732.md), and the amount of any basis adjustment under [section 734(b)](/cfr/26/734.md?p=b), the partnership's basis in the contract (including the uncompleted property, if applicable) immediately prior to the distribution is equal to—

        (1) The partnership's allocable contract costs (including transaction costs);

        (2) Increased (or decreased) by the amount of cumulative taxable income (or loss) recognized by the partnership on the contract through the date of the distribution (including amounts recognized as a result of the constructive completion); and

        (3) Decreased by the amounts that the partnership has received or reasonably expects to receive under the contract.

      - (E) **Section 751—** (1) In general. Contracts accounted for under a long-term contract method of accounting are unrealized receivables within the meaning of [section 751(c)](/cfr/26/751.md?p=c). For purposes of [section 751](/cfr/26/751.md), the amount of ordinary income or loss attributable to a contract accounted for under a long-term contract method of accounting is the amount of income or loss that the partnership would take into account under the constructive completion rules of [paragraph (k)(2)](#k-2) of this section if the contract were disposed of for its fair market value in a constructive completion transaction, adjusted to account for any income or loss from the contract that is allocated under [section 706](/cfr/26/706.md) to that portion of the taxable year of the partnership ending on the date of the distribution, sale, or exchange.

        (2) Ordering rules. Because the distribution of a contract accounted for under a long-term contract method of accounting is the distribution of an unrealized receivable, [section 751(b)](/cfr/26/751.md?p=b) may apply to the distribution. A partnership that distributes a contract accounted for under a long-term contract method of accounting must apply [paragraph (k)(2)(ii)](#k-2-ii) of this section before applying the rules of [section 751(b)](/cfr/26/751.md?p=b) to the distribution.

  - (3) **Step-in-the-shoes transactions—**
    - (i) **Scope.** Except as otherwise provided in [paragraph (k)(3)(v)(D)](#k-3-v-D) of this section, the step-in-the-shoes rules in this [paragraph (k)(3)](#k-3) apply to the following transactions that result in a change in the taxpayer responsible for reporting income from a contract accounted for using a long-term contract method of accounting (step-in-the-shoes transactions)—
      - (A) Transfers to which [section 361](/cfr/26/361.md) applies if the transfer is in connection with a reorganization described in section [368(a)(1)(A)](/cfr/26/368.md?p=a-1-A), [(C)](/cfr/26/368.md?p=a-1-C) or [(F)](/cfr/26/368.md?p=a-1-F);
      - (B) Transfers to which [section 361](/cfr/26/361.md) applies if the transfer is in connection with a reorganization described in section [368(a)(1)(D)](/cfr/26/368.md?p=a-1-D) or [(G)](/cfr/26/368.md?p=a-1-G), provided the requirements of section [354(b)(1)(A)](/cfr/26/354.md?p=b-1-A) and [(B)](/cfr/26/354.md?p=b-1-B) are met;
      - (C) Distributions to which [section 332](/cfr/26/332.md) applies, provided the contract is transferred to an 80-percent distributee;
      - (D) Transfers described in [section 351](/cfr/26/351.md);
      - (E) Transfers to which [section 361](/cfr/26/361.md) applies if the transfer is in connection with a reorganization described in [section 368(a)(1)(D)](/cfr/26/368.md?p=a-1-D) with respect to which the requirements of [section 355](/cfr/26/355.md) (or so much of [section 356](/cfr/26/356.md) as relates to [section 355](/cfr/26/355.md)) are met;
      - (F) Transfers (e.g., sales) of S corporation stock;
      - (G) Conversion to or from an S corporation;
      - (H) Members joining or leaving a consolidated group;
      - (I) Contributions of contracts accounted for under a long-term contract method of accounting to which [section 721(a)](/cfr/26/721.md?p=a) applies;
      - (J) Contributions of property (other than contracts accounted for under a long-term contract method of accounting) to a partnership that holds a contract accounted for under a long-term contract method of accounting;
      - (K) Transfers of partnership interests (other than transfers which cause the partnership to terminate under [section 708(b)(1)(A)](/cfr/26/708.md?p=b-1-A));
      - (L) Distributions to which [section 731](/cfr/26/731.md) applies (other than the distribution of the contract); and
      - (M) **Any other transaction designated in the Internal Revenue Bulletin by the Internal Revenue Service.** See [§ 601.601(d)(2)(ii)](/cfr/26/601.601.md?p=d-2-ii) of this chapter.
    - (ii) **Old taxpayer—**
      - (A) **In general.** The new taxpayer will “step into the shoes” of the old taxpayer with respect to the contract. Thus, the old taxpayer's obligation to account for the contract terminates on the date of the transaction and is assumed by the new taxpayer, as set forth in [paragraph (k)(3)(iii)](#k-3-iii) of this section. As a result, an old taxpayer using the PCM is required to recognize income from the contract based on the cumulative allocable contract costs incurred as of the date of the transaction. Similarly, an old taxpayer using the CCM is not required to recognize any revenue and may not deduct allocable contract costs incurred with respect to the contract.
      - (B) **Gain realized on the transaction.** The amount of gain the old taxpayer realizes on the transfer of a contract in a step-in-the-shoes transaction must be determined after application of [paragraph (k)(3)(ii)(A)](#k-3-ii-A) of this section using the rules of [paragraph (k)(2)](#k-2) of this section that apply to constructive completion transactions. (The amount of gain realized on a transfer of a contract is relevant, for example, in determining the amount of gain recognized with respect to the contract in a [section 351](/cfr/26/351.md) transaction in which the old taxpayer receives from the new taxpayer money or property other than stock of the transferee.)
    - (iii) **New taxpayer—**
      - (A) **Method of accounting.** Beginning on the date of the transaction, the new taxpayer must account for the long-term contract by using the same method of accounting used by the old taxpayer prior to the transaction. The same method of accounting must be used for such contract regardless of whether the old taxpayer's method is the new taxpayer's principal method of accounting under [§ 1.381(c)(4)-1(b)(3)](/cfr/26/1.381..1.md) or whether the new taxpayer is otherwise eligible to use the old taxpayer's method. Thus, if the old taxpayer uses the PCM to account for the contract, the new taxpayer steps into the shoes of the old taxpayer with respect to its completion factor and percentage of completion methods (such as the 10-percent method), even if the new taxpayer has not elected such methods for similarly classified contracts. Similarly, if the old taxpayer uses the CCM, the new taxpayer steps into the shoes of the old taxpayer with respect to the CCM, even if the new taxpayer is not otherwise eligible to use the CCM. However, the new taxpayer is not necessarily bound by the old taxpayer's method for similarly classified contracts entered into by the new taxpayer subsequent to the transaction and must apply general tax principles, including [section 381](/cfr/26/381.md), to determine the appropriate method to account for these subsequent contracts. To the extent that general tax principles allow the taxpayer to account for similarly classified contracts using a method other than the old taxpayer's method, the taxpayer is not required to obtain the consent of the Commissioner to begin using such other method.
      - (B) **Contract price.** In the case of a long-term contract that has been accounted for under PCM, the total contract price for the new taxpayer is the sum of any amounts the old taxpayer or the new taxpayer has received or reasonably expects to receive under the contract consistent with [paragraph (b)(4)](#b-4) of this section. Similarly, the gross contract price in the case of a long-term contract accounted for under the CCM includes all amounts the old taxpayer or the new taxpayer is entitled by law or by contract to receive consistent with [paragraph (d)(3)](#d-3) of this section.
      - (C) **Contract costs.** Total allocable contract costs for the new taxpayer are the allocable contract costs as defined under [paragraph (b)(5)](#b-5) of this section incurred by either the old taxpayer prior to, or the new taxpayer after, the transaction. Thus, any payments between the old taxpayer and the new taxpayer with respect to the contract in connection with the transaction are not treated as allocable contract costs.
    - (iv) **Special rules related to certain corporate and partnership transactions—**
      - (A) **Old taxpayer—** basis adjustment—(1) In general. Except as provided in paragraph (k)(3)(iv)(A)(2) of this section, in the case of a transaction described in paragraph [(k)(3)(i)(D)](#k-3-i-D), [(E)](#k-3-i-E), or [(I)](#k-3-i-I) of this section, the old taxpayer must adjust its basis in the stock or partnership interest of the new taxpayer by—

        (i) Increasing such basis by the amount of gross receipts the old taxpayer has recognized under the contract; and

        (ii) Reducing such basis by the amount of gross receipts the old taxpayer has received or reasonably expects to receive under the contract (except to the extent such gross receipts give rise to a liability other than a liability described in [section 357(c)(3)](/cfr/26/357.md?p=c-3)).

        (2) Basis adjustment in excess of stock or partnership interest basis. If the old and new taxpayer do not join in the filing of a consolidated Federal income tax return, the old taxpayer may not adjust its basis in the stock or partnership interest of the new taxpayer under paragraph (k)(3)(iv)(A)(1) of this section below zero and the old taxpayer must recognize ordinary income to the extent the basis in the stock or partnership interest of the new taxpayer otherwise would be adjusted below zero. If the old and new taxpayer join in the filing of a consolidated Federal income tax return, the old taxpayer must create an (or increase an existing) excess loss account to the extent the basis in the stock of the new taxpayer otherwise would be adjusted below zero under paragraph (k)(3)(iv)(A)(1) of this section. See § [1.1502-19](/cfr/26/1.1502-19.md) and [1.1502-32(a)(3)(ii)](/cfr/26/1.1502-32.md?p=a-3-ii).

        (3) Subsequent dispositions of certain contracts. If the old taxpayer disposes of a contract in a transaction described in paragraph [(k)(3)(i)(D)](#k-3-i-D), [(E)](#k-3-i-E), or [(I)](#k-3-i-I) of this section that the old taxpayer acquired in a transaction described in paragraph [(k)(3)(i)(D)](#k-3-i-D), [(E)](#k-3-i-E), or [(I)](#k-3-i-I) of this section, the basis adjustment rule of this [paragraph (k)(3)(iv)(A)](#k-3-iv-A) is applied by treating the old taxpayer as having recognized the amount of gross receipts recognized by the previous old taxpayer under the contract and any amount recognized by the previous old taxpayer with respect to the contract in connection with the transaction in which the old taxpayer acquired the contract. In addition, the old taxpayer is treated as having received or as reasonably expecting to receive under the contract any amount the previous old taxpayer received or reasonably expects to receive under the contract. Similar principles will apply in the case of multiple successive transfers described in paragraph [(k)(3)(i)(D)](#k-3-i-D), [(E)](#k-3-i-E), or [(I)](#k-3-i-I) of this section involving the contract.

      - (B) **New taxpayer—** (1) Contract price adjustment. Generally, payments between the old taxpayer and the new taxpayer with respect to the contract in connection with the transaction do not affect the contract price. Notwithstanding the preceding sentence and [paragraph (k)(3)(iii)(B)](#k-3-iii-B) of this section, however, in the case of transactions described in paragraph [(k)(3)(i)(B)](#k-3-i-B), [(D)](#k-3-i-D), [(E)](#k-3-i-E), or [(I)](#k-3-i-I) of this section, the total contract price (or gross contract price) must be reduced to the extent of any amount recognized by the old taxpayer with respect to the contract in connection with the transaction (e.g., any amount recognized under [section 351(b)](/cfr/26/351.md?p=b) or [section 357](/cfr/26/357.md) that is attributable to the contract and any income recognized by the old taxpayer pursuant to the basis adjustment rule of [paragraph (k)(3)(iv)(A)](#k-3-iv-A) of this section).

        (2) Basis in contract. The new taxpayer's basis in a contract (including the uncompleted property, if applicable) acquired in a transaction described in [paragraphs (k)(3)(i)(A) through (E)](#k-3-i-A..k-3-i-E) or [paragraph (k)(3)(i)(I)](#k-3-i-I) of this section will be computed under [section 362](/cfr/26/362.md), [section 334](/cfr/26/334.md), or [section 723](/cfr/26/723.md), as applicable. Upon a new taxpayer's completion (actual or constructive) of a CCM or a PCM contract acquired in a transaction described in [paragraphs (k)(3)(i)(A) through (E)](#k-3-i-A..k-3-i-E) or [paragraph (k)(3)(i)(I)](#k-3-i-I) of this section, the new taxpayer's basis in the contract (including the uncompleted property, if applicable) is reduced to zero. The new taxpayer is not entitled to a deduction or loss in connection with any basis reduction pursuant to this paragraph (k)(3)(iv)(B)(2).

      - (C) **Definition of old taxpayer and new taxpayer for certain partnership transactions.** For purposes of paragraphs [(k)(3)(ii)](#k-3-ii), [(iii)](#k-3-iii) and [(iv)](#k-3-iv) of this section, in the case of a transaction described in [paragraph (k)(3)(i)(I)](#k-3-i-I) of this section, the partner contributing the contract to the partnership is treated as the old taxpayer, and the partnership receiving the contract from the partner is treated as the new taxpayer.
      - (D) **Exceptions to step-in-the-shoes rules for S corporations.** Upon a transfer described in [paragraph (k)(3)(i)(F)](#k-3-i-F) of this section or a conversion described in [paragraph (k)(3)(i)(G)](#k-3-i-G) of this section, paragraphs [(k)(3)(ii)](#k-3-ii) and [(iii)](#k-3-iii) of this section apply to a contract accounted for under a long-term contract method of accounting only if the S corporation's books are closed under [section 1362(e)(3)](/cfr/26/1362.md?p=e-3), [section 1362(e)(6)(C)](/cfr/26/1362.md?p=e-6-C), [section 1362(e)(6)(D)](/cfr/26/1362.md?p=e-6-D), [section 1377(a)(2)](/cfr/26/1377.md?p=a-2), or [§ 1.1502-76](/cfr/26/1.1502-76.md) on the date of the transfer or conversion. In these cases, the corporation is treated as both the old taxpayer and the new taxpayer for purposes of paragraphs [(k)(3)(ii)](#k-3-ii) and [(iii)](#k-3-iii) of this section. In all other cases involving these transfers, the corporation shall compute its income or loss from each contract accounted for under a long-term contract method of accounting for the period that includes the date of the transaction as though no change in taxpayer had occurred with respect to the contract, and must allocate the income or loss from the contract for that period in accordance with the rules generally applicable to transfers of S corporation stock and conversions to or from S corporation status. This [paragraph (k)(3)(iv)(D)](#k-3-iv-D) is applicable for transactions on or after July 16, 2004. In addition, this [paragraph (k)(3)(iv)(D)](#k-3-iv-D) may be relied upon for transactions on or after May 15, 2002.
    - (v) **Special rules relating to certain partnership transactions—**
      - (A) **Section 704(c)—** (1) Contributions of contracts. The principles of [section 704(c)(1)(A)](/cfr/26/704.md?p=c-1-A), [section 737](/cfr/26/737.md), and the regulations thereunder apply to income or loss with respect to a contract accounted for under a long-term contract method of accounting that is contributed to a partnership. The amount of built-in income or built-in loss attributable to a contributed contract that is subject to [section 704(c)(1)(A)](/cfr/26/704.md?p=c-1-A) is determined as follows. First, the contributing partner must take into account any income or loss required under [paragraph (k)(3)(ii)(A)](#k-3-ii-A) of this section for the period ending on the date of the contribution. Second, the partnership must determine the amount of income or loss that the contributing partner would take into account if the contract were disposed of for its fair market value in a constructive completion transaction. This calculation is treated as occurring immediately after the partner has applied [paragraph (k)(3)(ii)(A)](#k-3-ii-A) of this section, but before the contribution to the partnership. Finally, this amount is reduced by the amount of income, if any, that the contributing partner is required to recognize as a result of the contribution.

        (2) Revaluations of partnership property. The principles of [section 704(c)](/cfr/26/704.md?p=c) and [§ 1.704-3](/cfr/26/1.704-3.md) apply to allocations of income or loss with respect to a long-term contract that is revalued by a partnership under [§ 1.704-1(b)(2)(iv)(f)](/cfr/26/1.704-1.md?p=b-2-iv-f). The amount of built-in income or built-in loss attributable to such a contract is equal to the amount of income or loss that would be taken into account if, at the time of the revaluation, the contract were disposed of for its fair market value in a constructive completion transaction.

        (3) Allocation methods. In the case of a contract accounted for under the CCM, any built-in income or loss under [section 704(c)](/cfr/26/704.md?p=c) is taken into account in the year the contract is completed. In the case of a contract accounted for under a long-term contract method of accounting other than the CCM, any built-in income or loss under [section 704(c)](/cfr/26/704.md?p=c) must be taken into account in a manner that reasonably accounts for the [section 704(c)](/cfr/26/704.md?p=c) income or loss over the remaining term of the contract.

      - (B) **Basis adjustments under sections 743(b) and 734(b).** For purposes of §§ [1.743-1(d)](/cfr/26/1.743-1.md?p=d), [1.755-1(b)](/cfr/26/1.755-1.md?p=b), and [1.755-1(c)](/cfr/26/1.755-1.md?p=c), the amount of ordinary income or loss attributable to a contract accounted for under a long-term contract method of accounting is the amount of income or loss that the partnership would take into account under the constructive completion rules of [paragraph (k)(2)](#k-2) of this section if, at the time of the sale of a partnership interest or the distribution to a partner, the partnership disposed of the contract for its fair market value in a constructive completion transaction. If all or part of the transferee's basis adjustment under [section 743(b)](/cfr/26/743.md?p=b) or the partnership's basis adjustment under [section 734(b)](/cfr/26/734.md?p=b) is allocated to a contract accounted for under a long-term contract method of accounting, the basis adjustment shall reduce or increase, as the case may be, the affected party's income or loss from the contract. In the case of a contract accounted for under the CCM, the basis adjustment is taken into account in the year in which the contract is completed. In the case of a contract accounted for under a long-term contract method of accounting other than the CCM, the portion of that basis adjustment that is recovered in each taxable year of the partnership must be determined by the partnership in a manner that reasonably accounts for the adjustment over the remaining term of the contract.
      - (C) **Cross reference.** See [paragraph (k)(2)(iv)(E)](#k-2-iv-E) of this section for rules relating to the application of [section 751](/cfr/26/751.md) to the transfer of an interest in a partnership holding a contract accounted for under a long-term contract method of accounting.
      - (D) **Exceptions to step-in-the-shoes rules.** Upon a contribution described in [paragraph (k)(3)(i)(J)](#k-3-i-J) of this section, a transfer described in [paragraph (k)(3)(i)(K)](#k-3-i-K) of this section, or a distribution described in [paragraph (k)(3)(i)(L)](#k-3-i-L) of this section, paragraphs [(k)(3)(ii)](#k-3-ii) and [(iii)](#k-3-iii) of this section apply to a contract accounted for under a long-term contract method of accounting only if the partnership's books are properly closed with respect to that contract under [section 706](/cfr/26/706.md). In these cases, the partnership is treated as both the old taxpayer and the new taxpayer for purposes of paragraphs [(k)(3)(ii)](#k-3-ii) and [(iii)](#k-3-iii) of this section. In all other cases involving these transactions, the partnership shall compute its income or loss from each contract accounted for under a long-term contract method of accounting for the period that includes the date of the transaction as though no change in taxpayer had occurred with respect to the contract, and must allocate the income or loss from the contract for that period under a reasonable method complying with [section 706](/cfr/26/706.md).
  - (4) **Anti-abuse rule.** Notwithstanding this [paragraph (k)](#k), in the case of a transaction entered into with a principal purpose of shifting the tax consequences associated with a long-term contract in a manner that substantially reduces the aggregate U.S. Federal income tax liability of the parties with respect to that contract, the Commissioner may allocate to the old (or new) taxpayer the income from that contract properly allocable to the old (or new) taxpayer. For example, the Commissioner may reallocate income from a long-term contract in a transaction in which a contract accounted for using the CCM, or using the PCM where the old taxpayer has received advance payments in excess of its contribution to the contract, is transferred to a tax indifferent party (e.g., a foreign person not subject to U.S. Federal income tax).
  - (5) **Examples.** The following examples illustrate the rules of this [paragraph (k)](#k). For purposes of these examples, it is assumed that the contract is a long-term construction contract accounted for using the PCM prior to the transaction unless stated otherwise and the contract is not transferred with a principal purpose of shifting the tax consequences associated with a long-term contract in a manner that substantially reduces the aggregate U.S. Federal income tax liability of the parties with respect to that contract. The examples are as follows:
  - (6) **Effective date.** Except as provided in [paragraph (k)(3)(iv)(D)](#k-3-iv-D) of this section, this [paragraph (k)](#k) is applicable for transactions on or after May 15, 2002. Application of the rules of this [paragraph (k)](#k) to a transaction that occurs on or after May 15, 2002 is not a change in method of accounting.

# §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)](/cfr/26/1.460-4.md?p=b) (PCM), the completed-contract method described in [§ 1.460-4(d)](/cfr/26/1.460-4.md?p=d) (CCM), or the percentage-of-completion/capitalized-cost method described in [§ 1.460-4(e)](/cfr/26/1.460-4.md?p=e) (PCCM). Exempt construction contracts described in [§ 1.460-3(b)](/cfr/26/1.460-3.md?p=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 production-period interest under [paragraph (b)(2)(v)](#b-2-v) of this section). [Paragraph (b)](#b) of this section describes the regular cost allocation methods for contracts subject to the PCM. [Paragraph (c)](#c) of this section describes an elective simplified cost allocation method for contracts subject to the PCM. [Paragraph (d)](#d) of this section describes the cost allocation methods for exempt construction contracts reported using the CCM. [Paragraph (e)](#e) of this section describes the cost allocation rules for contracts subject to the PCCM. [Paragraph (f)](#f) of this section describes additional rules applicable to the cost allocation methods described in this section. [Paragraph (g)](#g) of this section provides rules concerning consistency in method of allocating costs to long-term contracts.
- (b) **Cost allocation method for contracts subject to PCM—**
  - (1) **In general.** Except as otherwise provided in [paragraph (b)(2)](#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)](/cfr/26/1.263A-1.md?p=e..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 long-term contract). However, see [paragraph (c)](#c) of this section concerning an election to allocate contract costs using the simplified cost-to-cost method. As in [section 263A](/cfr/26/263A.md), the use of the practical capacity concept is not permitted. See [§ 1.263A-2(a)(4)](/cfr/26/1.263A-2.md?p=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)](/cfr/26/1.263A-11.md?p=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](/cfr/26/1.471-1.md) 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 long-term 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, 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 long-term contract when the component is dedicated, under principles similar to those in [§ 1.263A-11(b)(2)](/cfr/26/1.263A-11.md?p=b-2). A taxpayer maintaining inventories under [§ 1.471-1](/cfr/26/1.471-1.md) 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)](/cfr/26/1.263A-2.md?p=b) and [(c)](/cfr/26/1.263A-2.md?p=c).
    - (iv) **Costs identified under cost-plus long-term contracts and federal long-term contracts.** To the extent not otherwise allocated to the contract under this [paragraph (b)](#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)](/cfr/26/460.md?p=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)](/cfr/26/1.263A-8.md?p=b) (without regard to the exclusion for long-term contracts under [§ 1.263A-8(d)(2)(v)](/cfr/26/1.263A-8.md?p=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)](/cfr/26/263A.md?p=f). See [§§ 1.263A-8 to 1.263A-12](/cfr/26/1.263A-8..1.263A-12.md) generally.
      - (B) **Production period.** Notwithstanding § [1.263A-12(c)](/cfr/26/1.263A-12.md?p=c) and [(d)](/cfr/26/1.263A-12.md?p=d), for purposes of this [paragraph (b)(2)(v)](#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)](/cfr/26/1.460-1.md?p=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

        (2) Ends on the date that the contract is completed, as defined in [§ 1.460-1(c)(3)](/cfr/26/1.460-1.md?p=c-3).

      - (C) **Application of section 263A(f).** For purposes of this [paragraph (b)(2)(v)](#b-2-v), [section 263A(f)(1)(B)(iii)](/cfr/26/263A.md?p=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-by-contract 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)](/cfr/26/1.263A-1.md?p=e-3-ii-P) and [(iii)(B)](/cfr/26/1.263A-1.md?p=e-3-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)](/cfr/26/1.460-1.md?p=b-9)), to its long-term contracts.
    - (vii) **Service costs—**
      - (A) **Simplified service cost method—**
        - (1) **In general.** To use the simplified service cost method under [§ 1.263A-1(h)](/cfr/26/1.263A-1.md?p=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)](#b-2-vii-A):
      - (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)](/cfr/26/1.263A-1.md?p=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)](/cfr/26/1.263A-1.md?p=f-2) or [(3)](/cfr/26/1.263A-1.md?p=f-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)](#b) of this section, a taxpayer may elect to use the simplified cost-to-cost method, which is authorized under [section 460(b)(3)(A)](/cfr/26/460.md?p=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 therefore must be allocated to the contract under the simplified cost-to-cost method. An electing taxpayer must use the simplified cost-to-cost method to apply the look-back method under [§ 1.460-6](/cfr/26/1.460-6.md) and to determine alternative minimum taxable income under [§ 1.460-4(f)](/cfr/26/1.460-4.md?p=f).
  - (2) **Election.** A taxpayer makes an election under this [paragraph (c)](#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)](/cfr/26/1.460-4.md?p=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)](#d-3) of this section, 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)](/cfr/26/1.263A-1.md?p=e-2-i) and all indirect costs either as provided in [§ 1.263A-1(e)(3)](/cfr/26/1.263A-1.md?p=e-3) or as provided in [paragraph (d)(2)](#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)](#d-2) must allocate the following costs to an exempt construction contract, other than a contract described in [paragraph (d)(3)](#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)](/cfr/26/105.md?p=d) as it existed prior to its repeal in 1983), shift differential, payroll taxes, and 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](/cfr/26/164.md), 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)](#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](/cfr/26/174.md) and the regulations thereunder);
      - (F) Losses under [section 165](/cfr/26/165.md) 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;
      - (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)](/cfr/26/401.md?p=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](/cfr/26/404A.md) and the regulations thereunder; payments pursuant to a wage continuation plan under [section 105(d)](/cfr/26/105.md?p=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](/cfr/26/263A.md), unless the taxpayer estimates, when entering into the contract, that it will be completed within two years of the contract commencement date, and the taxpayer satisfies the gross receipts test of [section 448(c)](/cfr/26/448.md?p=c) described in [§ 1.460-3(b)(3)](/cfr/26/1.460-3.md?p=b-3) for the taxable year in which the contract is entered into.
- (e) **Cost allocation rules for contracts subject to the PCCM.** A taxpayer must use the cost allocation rules described in [paragraph (b)](#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)](#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)](/cfr/26/162.md?p=c)).
  - (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)](/cfr/26/1.460-1.md?p=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)](/cfr/26/446.md?p=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)](/cfr/26/481.md?p=a) adjustment will not be permitted or required.