Tax savings opportunities for taxable contract acquisitions.

• Author: Hurt, Rebecca K.

Taxpayers using percentage-of-completion accounting have an opportunity for gross profit deferral following a mid-contract change in ownership. Taxpayers that acquire contracts in taxable transactions may wish to consider opportunities to defer gross profit resulting from the deemed constructive-completion rules that apply to taxable contract sales. In addition, an exception may exist that provides a current deduction for interest that must typically be allocated to the contract.

Percentage-of-Completion Overview

The percentage-of-completion method of accounting (PCM) is prescribed by Sec. 460 for building, installation, construction, or manufacturing contracts not completed in the tax year in which they are entered. Further, to qualify for long-term-contract treatment, manufacturing contracts must either be unique in nature or relate to the manufacture of items routinely requiring more than 12 months to complete (Sec. 460(f)(2)).

Under the PCM, a taxpayer recognizes revenue over the life of the contract. Taxpayers include in income a portion of the total contract price based on costs incurred and allocable to the long-term contract. As such, the taxpayer computes a completion factor, which is the ratio of costs incurred to estimated total allocable contract costs. Next, the taxpayer computes cumulative gross receipts from the contract by multiplying the completion factor by the total contract price. The taxpayer then subtracts its gross receipts recognized through the end of the prior year from its cumulative gross receipts at year end. Regs. Sec. 1.460-4(b)(2) provides that current-year costs incurred on the contracts are then deducted from the year's gross receipts to arrive at gross profit.

Constructive Completion

The constructive completion rules described in Regs. Sec. 1.460-4(k)(2) apply to taxable contract sales, including deemed-asset sales under Sec. 338, of contracts accounted for using the PCM. In a constructive completion transaction, the selling taxpayer is treated as having completed the contract as of the day of the transaction and thus must recognize income from the contract. The purchasing taxpayer is treated as having entered into a new contract on the date of the transaction. If Sec. 460 applies, the total contract price is the amount that the new taxpayer expects to receive under the contract reduced by the allocable consideration paid to acquire the contracts. The new taxpayer's contract costs do not include any...