Prop. Regs. on Mid-Contract Change in Taxpayer Under Long-Term Contract Method

Proposed regulations re-leased on Feb. 15, 2001 addressed the tax treatment of a change in taxpayer prior to completion of a long-term contract accounted for under a long-term contract method. A mid-contract change occurs when a transaction makes a new taxpayer responsible for reporting the income from a long-term contract.

Sec. 460

Sec. 460 and the regulations thereunder provide specific accounting methods for determining income from long-term contracts. In general, a contract begun in one year and completed in a subsequent year is a long-term contract. The specific accounting methods include the percentage-of-completion method (PCM), the completed-contract method (CCM) and the percentage-of-completion/capitalized-cost method (PCCM).

Background

In 1990, Treasury and the IRS issued proposed regulations addressing the treatment of mid-contract changes in taxpayers, for purposes of applying the look-back method (which applied a step-in-the-shoes approach). They subsequently withdrew the proposed regulations.

Final Sec. 460 regulations, issued on Jan. 10, 2001, reserved for future guidance provisions dealing with mid-contract changes in taxpayer.

Overview

The newly issued proposed regulations would divide the rules into two categories based on the type of transaction. The two categories appear to respond to criticism of the withdrawn proposed regulations that the step-in-the-shoes approach applied to all contract transferees was inappropriate in the case of taxable dispositions.

Prop. Regs. Sec. 1.460-4(k) would apply if, before completion of a long-term contract accounted for under Sec. 460, a transaction transpires that makes a new taxpayer responsible for reporting the income from the same contract. In addition to such a mid-contract change in taxpayer, under the proposed regulations, a change in status to or from a taxable to tax-exempt entity or foreign to domestic entity would constitute a change in taxpayer. A contract would stand as the same contract if the terms were not substantially changed in connection with the transaction.

The proposed regulations would characterize the entity that was an original party to the long-term contract (and, therefore, the transferor of the contract) as the "old taxpayer," and the entity made responsible for reporting the income from the same contract (the transferee) as the "new taxpayer." For this purpose, an "old taxpayer" would include any predecessors of the old taxpayer.

Analysis of Rules Based on Type of Transaction

As proposed, the rules for a mid-year change in taxpayer of a long-term contract would be divided based on whether the transaction is (1) a step-in-the-shoes transaction or (2) a constructive completion transaction.

For purposes of Prop. Regs. Sec. 1.460-4(k), step-in-the-shoes rules would apply to (1) transactions described in Secs. 381 (generally, tax-free acquisitive reorganizations and complete subsidiary liquidations), 351 (transfers to controlled corporations), and 368(a)(1)(D) by reason of Sec. 355 (divisive D reorganizations); (2) transfers of S stock; (3) conversion to or from an S corporation; (4) members leaving or joining a consolidated group; and (5) any other transaction that the IRS designates in the Internal Revenue Bulletin.

The constructive completion rules would apply to all other transactions and, in general, include taxable sales under Sec. 1001 and deemed asset sales under Sec. 338.

Step-in-the-Shoes Transactions

In step-in-the-shoes transactions, a new taxpayer assumes an old taxpayer's obligation to account for the contract, and the old taxpayer's obligation terminates on the transaction date. An old taxpayer using the PCM would have to recognize income based on cumulative allocable contract costs incurred as of the transaction date. An old taxpayer using the CCM would not have to recognize any revenue or take any deduction for allocable contract costs incurred on account of the contract, except in the case of a tax-avoidance transaction.

The new taxpayer would have to use the old taxpayer's accounting method for the contract, regardless of the new taxpayer's principal accounting method, whether the new taxpayer is otherwise eligible to use the old taxpayer's method, and whether the new taxpayer makes applicable elections. For similarly classified long-term contracts entered into by a new taxpayer subsequent to the transaction, the new taxpayer can use a method that differs from the old taxpayer's method for such contracts (if authorized by general tax principles), without IRS consent.

In a transaction in which the transferor (old taxpayer) takes a carryover basis in the stock of the transferee (new taxpayer), the proposed regulations would require the transferor to adjust its basis in the transferee's stock for the portion of the stock received in exchange for the long-term contract by the difference between the amount the transferor recognized with respect to the contract and the amount the transferor received or reasonably expects to receive. The rules would not allow the transferor to reduce its basis in the transferee stock below zero.

Constructive Completion Transactions

In constructive completion transactions, the proposed regulations would deem the old taxpayer as completing the contract on the transaction date. The old taxpayer would recognize income from the long-term contract based on the total contract price (or gross contract price). The old taxpayer's total contract price (or gross contract price) would be the sum of any amounts realized from the transaction allocable to the contract and any amounts reasonably expected to be received by the old taxpayer under the contract after the transaction, reduced by any amounts paid by the old taxpayer to the new taxpayer, and by any transaction costs allocable to the contract.

The Service would treat the new taxpayer as though he entered into a new contract as of the transaction date and would determine whether the new contract should be classified as a long-term contract. If the new taxpayer accounts for the contract using the PCM, the total contract price would be any amount the new taxpayer reasonably expects to receive under the contract—consistent with Regs. Sec. 1.460-4(b)(4) and adjusted for any consideration paid or received as a result of the transaction, and by any transaction costs allocable to the contract. The gross contract price for a contract accounted for using the CCM would be all amounts the new taxpayer is entitled to receive, adjusted for any consideration paid or received as a result of the transaction allocable to the contract.

Look-Back Method

The proposed regulations include revisions to Regs. Sec. 1.460-6(g), which address the application of the look-back method to a mid-contract change in taxpayer.

For step-in-the-shoes transactions, the look-back method would apply to pre- and post-transaction years by the new taxpayer on contract completion, taking into account all amounts reasonably expected to be received by either the new or old taxpayer and all allocable contract costs incurred by both parties. The rules would entitle the new taxpayer to receive interest on hypothetical overpayments of tax for both pre- and post-transaction years. The old taxpayer would remain secondarily liable for the payment of any interest for pre-transaction years.

For post-transaction tax years, the proposed regulations would require the new taxpayer to use the same look-back method it uses for other contracts to determine any hypothetical under- or overpayment of tax and the time period for computing interest on these amounts.

For step-in-the-shoes transactions, the proposed regulations would require the old taxpayer to provide the new taxpayer with information to enable the new taxpayer to make the necessary look-back computations for long-term contracts accounted for by the old taxpayer under the PCM or PCCM.

For constructive completion transactions, the old taxpayer would apply the look-back method on the transaction date to pre-transaction years. If the taxpayer uses the PCM or PCCM to account for the contract, the new taxpayer would apply the look-back rules to post-transaction years on contract completion.

The proposed regulations would be effective for transactions occurring on or after the date the proposed regulations appear in the Federal Register as final regulations.

From Irwin Leib, CPA, and Alexa Mortenson, J.D., Washington, DC