[Federal Register Volume 66, Number 33 (Friday, February 16, 2001)]
[Proposed Rules]
[Pages 10643-10650]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-1992]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-105946-00]
RIN 1545-AY31


Mid-contract Change in Taxpayer

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations concerning a mid-
contract change in taxpayer of a contract that has been accounted for 
under a long-term contract method of accounting. A taxpayer that is a 
party to such a contract will be affected by these proposed 
regulations. This document also provides notice of a public hearing on 
the proposed regulations.

DATES: Written comments must be received by May 17, 2001. Outlines of 
oral comments to be presented at the public hearing scheduled for June 
13, 2001, at 10 a.m. must be received by May 30, 2001.

ADDRESSES: Send submissions to CC:M&SP:RU (REG-105946-00), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand

[[Page 10644]]

delivered Monday through Friday between the hours of 8 a.m. and 5 p.m. 
to: CC:M&SP:RU (REG-105946-00), Courier's Desk, Internal Revenue 
Service, 1111 Constitution Avenue, NW., Washington, DC. Alternatively, 
taxpayers may submit comments electronically via the Internet by 
selecting the ``Tax Regs'' option on the IRS Home Page, or by 
submitting comments directly to the IRS Internet site at http://
www.irs.gov/prod/tax__regs/regslist.html. The public hearing will be 
held in room 6718, Internal Revenue Building, 1111 Constitution Avenue, 
NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
John Aramburu or Leo F. Nolan II at (202) 622-4960; concerning 
submissions of comments, the hearing, and/or to be placed on the 
building access list to attend the hearing, Guy Traynor of the 
Regulations Unit at (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in this notice of proposed 
rulemaking have been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collections of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:FP:S:O, 
Washington, DC 20224. Comments on the collections of information should 
be received by April 17, 2001. Comments are specifically requested 
concerning:
     Whether the proposed collections of information are 
necessary for the proper performance of the functions of the Internal 
Revenue Service, including whether the information will have practical 
utility;
     The accuracy of the estimated burden associated with the 
proposed collections of information (see below);
     How the quality, utility, and clarity of the information 
to be collected may be enhanced;
     How the burden of complying with the proposed collections 
of information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
     Estimates of capital or start-up costs and costs of 
operation, maintenance, and purchase of services to provide 
information.
    The collection of information in this proposed regulation is in 
Sec. 1.460-6(g)(3)(ii)(C). The information collected in Sec. 1.460-
6(g)(3)(ii)(C) is required to provide certain recipients of long-term 
contracts with the information needed to make look-back calculations. 
This collection of information is mandatory. The likely respondents are 
for-profit entities.
    Estimated total reporting burden: 10,000 hours.
    Estimated average burden per respondent: 2 hours.
    Estimated number of respondents: 5000.
    Estimated annual frequency of responses: On occasion.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    Section 460 of the Internal Revenue Code was enacted by section 804 
of the Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 2085, 2358-
2361). Section 460 was amended by section 10203 of the Omnibus Budget 
Reconciliation Act of 1987, Public Law 100-203 (101 Stat. 1330, 1330-
394); by sections 1008(c) and 5041 of the Technical and Miscellaneous 
Revenue Act of 1988, Public Law 100-647 (102 Stat. 3342, 3438-3439 and 
3673-3676); by sections 7621 and 7811(e) of the Omnibus Budget 
Reconciliation Act of 1989, Public Law 101-239 (103 Stat. 2106, 2375-
2377 and 2408-2409); by section 11812 of the Omnibus Budget 
Reconciliation Act of 1990, Public Law 101-508 (104 Stat. 1388, 1388-
534 to 1388-536); by sections 1702(h)(15) and 1704(t)(28) of the Small 
Business Job Protection Act of 1996, Public Law 104-188 (110 Stat. 
1755, 1874, 1888); and by section 1211 of the Taxpayer Relief Act of 
1997, Public Law 105-34 (111 Stat. 788, 998-1000).
    Section 460(h) directs the Secretary to prescribe regulations to 
the extent necessary or appropriate to carry out the purpose of section 
460, including regulations to prevent a taxpayer from avoiding section 
460 by using related parties, pass-through entities, intermediaries, 
options, and other similar arrangements.

Explanation of Provisions

Overview

    Generally, manufacturing and construction contracts not completed 
within the taxable year they are entered into are long-term contracts. 
A manufacturing contract, however, is not a long-term contract unless 
it requires the manufacture of a unique item or an item normally 
requiring more than 12 months to complete. Section 460 generally 
requires that long-term contracts be accounted for under the 
percentage-of-completion method (PCM) and that taxpayers make a look-
back computation of interest to compensate the government (or the 
taxpayer) for any underestimation (overestimation) of income from the 
contract. However, home construction contracts and certain contracts of 
smaller construction contractors are exempt from these requirements. 
Moreover, residential builders are entitled to use the 70/30 
percentage-of-completion/ capitalized cost method (PCCM), and certain 
shipbuilders are entitled to use the 40/60 PCCM. A long-term contract 
or a portion of a long-term contract that is exempt from the PCM may be 
accounted for under any permissible method, including the completed 
contract method (CCM) or the exempt percentage-of-completion method 
(EPCM). These long-term contract methods of accounting (i.e., the PCM, 
PCCM, CCM and EPCM) are described in proposed Sec. 1.460-4. These 
proposed regulations address the Federal income tax treatment of a 
change in taxpayer prior to completion of a long-term contract 
accounted for under a long-term contract method of accounting.

Existing Guidance on Transfers of Long-term Contracts

    In the case of transactions not governed by section 381, such as 
those occurring prior to its effective date, numerous cases have 
required a taxpayer to take into income items that under its method of 
accounting would be deferred past the date of the transaction. These 
cases have involved both taxable and nontaxable transactions, e.g., 
liquidations and reorganizations. For example, in the case of a 
disposition of a long-term contract accounted for under the CCM, the 
transferor was required to recognize income earned on the contract 
prior to its transfer, with the amount earned determined under some 
variant of the PCM. These cases generally relied on section 446(b), 
section 482 and/or the

[[Page 10645]]

assignment of income doctrine to allocate income to the transferor. See 
e.g., Jud Plumbing and Heating, Inc. v. Commissioner, 153 F.2d 681 (5th 
Cir. 1946); Standard Paving Co. v. Commissioner, 190 F.2d 330 (10th 
Cir.), cert. denied, 342 U.S. 860 (1951); Central Cuba Sugar Co. v. 
Commissioner, 198 F.2d 214 (2nd Cir.), cert. denied, 344 U.S. 874 
(1952); Dillard-Waltermire, Inc. v. Campbell, 255 F.2d 433 (5th Cir. 
1958); and Midland-Ross Corp. v. United States, 485 F.2d 110 (6th Cir. 
1973). In addition, Sec. 1.451-5(f) of the regulations has been cited 
as support for taxing a transferor who has deferred advance payments 
under its long-term contract method of accounting. See Rotolo v. 
Commissioner, 88 T.C. 1500 (1987).
    Under section 381(c)(4), in the case of a section 381 transaction, 
an acquiring corporation generally must use the method of accounting 
used by the transferor. Further, regulations under Sec. 1.381(c)(4)-1 
require the acquiring corporation to take into account the transferor's 
items of income or deduction which, because of its method of 
accounting, were not required or permitted to be included or deducted 
by the transferor in computing taxable income prior to the date of the 
transfer. Consistent with section 381, the IRS has held that section 
381 generally requires a transferee to account for a long-term contract 
transferred pursuant to a section 381 transaction using the CCM used by 
the transferor and, thus, to report the entire gain or loss from the 
contract. Accordingly, the decisions in the Standard Paving line of 
cases are generally not applicable to transactions to which section 381 
applies. Rev. Rul. 70-83 (1970-1 C.B. 85). In addition, section 351 
generally has been interpreted to prevent recognition of gain or loss 
by a transferor from a section 351 transfer of partially completed 
long-term contracts accounted for by the transferor using the CCM. See 
GCM 39258 (July 13, 1984) applying Rev. Rul. 80-198 (1980-2 C.B. 113) 
(no gain or loss is recognized to a cash basis transferor with respect 
to unrealized accounts receivable and unrecognized accounts payable 
transferred in a section 351 transaction).
    In 1990, the IRS issued proposed regulations (REG-209308-86) (55 FR 
23755) that addressed the treatment of a mid-contract change in 
taxpayer of a contract accounted for using PCM for purposes of applying 
the look-back method. Generally, these proposed regulations provided 
that the successor to the contract ``stepped into the shoes'' of the 
predecessor with respect to the PCM. Thus, the successor was to 
continue to use the same PCM used by the predecessor both for purposes 
of reporting income under the contract and recomputing income under the 
look-back method. No look-back calculation was to be made until the 
successor completed the contract, and the successor was liable for 
look-back interest attributable to both pre- and post-transaction 
years. On the other hand, except in the case of taxable dispositions to 
unrelated parties, the successor could not recover look-back interest 
owed by the government that was attributable to pre-transaction years. 
These proposed regulations were withdrawn. One criticism of the 
regulations was that step-in-the-shoes treatment was inappropriate in 
the case of taxable dispositions.

Proposed Provisions

    Consistent with the existing guidance described above and in 
response to comments received on the 1990 proposed regulations, these 
proposed regulations divide the rules regarding a mid-contract change 
in taxpayer of a long-term contract accounted for under a long-term 
contract method into two categories--constructive completion 
transactions and step-in-the-shoes transactions. For this purpose, the 
step-in-the-shoes rules apply to the following transactions--
    (1) Transactions described in section 381 (i.e., liquidations under 
section 332 and reorganizations described in section 368(a)(1)(A), (C), 
(D), (F), or (G));
    (2) Transactions described in section 351;
    (3) Transactions described in section 368(a)(1)(D) with respect to 
which the requirements of section 355 (or so much of section 356 as 
relates to section 355) are met (divisive ``D'' reorganization);
    (4) Transfers (e.g. sales) of S corporation stock;
    (5) Conversion to or from an S corporation;
    (6) Members joining or leaving a consolidated group; and
    (7) Any other transaction designated in the Internal Revenue 
Bulletin by the Internal Revenue Service. See 26 CFR 601.601(d)(2)(ii).
    The constructive completion rules apply to all other transactions.
    A constructive completion transaction results in the taxpayer 
originally reporting income under the long-term contract (old taxpayer) 
recognizing income from the contract based on a contract price that 
takes into account any amounts realized from the transaction or paid by 
the old taxpayer to the taxpayer subsequently reporting income under 
the long-term contract (new taxpayer) that are allocable to the 
contract. Similarly, the new taxpayer in a constructive completion 
transaction is treated as though it entered into a new contract as of 
the date of the transaction, with the contract price taking into 
account the purchase price and any amount paid by the old taxpayer that 
is allocable to the contract.
    In the case of a step-in-the-shoes transaction, the old taxpayer's 
obligation to account for the contract terminates on the date of the 
transaction and is assumed by the new taxpayer. The new taxpayer must 
assume the old taxpayer's methods of accounting for the contract, with 
both the contract price and allocable contract costs based on amounts 
taken into account by both parties. However, in the case of a tax 
avoidance transaction, the IRS may allocate income with respect to a 
transferred long-term contract between the old and new taxpayers. 
Section Sec. 1.451-5(f) will not be applied to a mid-contract change in 
taxpayer of a contract accounted for under a long-term contract method.
    In the case of a step-in-the-shoes transaction in which the 
transferor's basis in the stock of the transferee is determined by 
reference to its basis of the property transferred, the basis in the 
stock of the transferee attributable to the transfer of a long-term 
contract will not be appropriate unless the amount previously received 
by the transferor under the long-term contract equates to the amount 
previously recognized as gross receipts by the transferor. Under both 
the PCM and the CCM, however, it is common for the amount received with 
respect to a long-term contract to differ from the amount recognized 
because the receipt of progress payments does not affect the 
recognition of income. To address this situation, the proposed 
regulations provide that, in the case of a section 351 transaction or a 
divisive ``D'' reorganization, the old taxpayer must adjust its basis 
in the stock of the new taxpayer by the difference between the amount 
the old taxpayer has recognized with respect to the contract and the 
amount the old taxpayer has received or reasonably expects to receive 
under the contract. The IRS and Treasury Department specifically 
request comments with respect to this rule.
    The proposed regulations also provide rules for applying the look-
back method in the case of a mid-contract change in taxpayer. For 
constructive completion transactions, the look-back method is applied 
by the old taxpayer with respect to pre-transaction years upon the 
transaction date and, if applicable, by the new taxpayer with respect 
to post-transaction years upon contract

[[Page 10646]]

completion. For step-in-the-shoes transactions, the look-back method is 
applied only by the new taxpayer upon contract completion. The new 
taxpayer must account for pre- and post-transaction years, with special 
rules governing the calculation of look-back interest in the case of 
pre-transaction years. The proposed regulations also require the old 
taxpayer in such cases to provide certain information to the new 
taxpayer in order to enable the new taxpayer to make the necessary 
look-back calculations.
    The proposed regulations reserve on whether a mid-contract change 
in taxpayer that results from a partnership transaction, including a 
transaction described in section 721, a transaction described in 
section 731, and a transfer (e.g., sale) of a partnership interest, 
should be treated as a constructive completion, or a step-in-the-shoes, 
transaction. Although these transactions are similar to other step-in-
the-shoes transactions, such as nonrecognition transactions (e.g., 
sections 351 and 332) and transactions where the party responsible for 
performing the contract has not changed (e.g., sales of S corporation 
stock and members joining or leaving consolidated groups), the IRS and 
Treasury Department are concerned that step-in-the-shoes treatment for 
these partnership transactions could more readily facilitate the 
shifting of income to tax indifferent parties than in other situations 
and thus are concerned about monitoring such activities solely through 
an anti-abuse rule. In addition, other issues, such as the treatment of 
long-term contracts under section 704(c), 751, and 752, significantly 
complicate, and could thwart, the application of the step-in-the-shoes 
rule with respect to mid-contract changes involving partnership 
transactions. The IRS and Treasury Department request comments on the 
appropriate treatment for mid-contract changes in taxpayer resulting 
from these partnership transactions.

Proposed Effective Date

    These regulations are proposed to be applicable for transactions on 
or after the date they are published in the Federal Register as final 
regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations. Pursuant to 
section 7805(f) of the Internal Revenue Code, this notice of proposed 
rulemaking will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.
    It is hereby certified that the collection of information in these 
regulations will not have a significant economic impact on a 
substantial number of small entities. This certification is based on 
the fact that the relevant information is already maintained by 
taxpayers. Therefore, a Regulatory Flexibility Analysis under the 
Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any electronic or written comments (a 
signed original and eight (8) copies) that are submitted timely to the 
IRS. The IRS and Treasury Department specifically request comments on 
the clarity of the proposed rule and how it could be made easier to 
understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for June 13, 2001, at 10 a.m. 
in room 6718, Internal Revenue Building, 1111 Constitution Avenue, NW., 
Washington, DC. Due to building security procedures, visitors must 
enter at the 10th Street entrance, located between Constitution and 
Pennsylvania Avenue, NW. In addition, all visitors must present photo 
identification to enter the building. Because of access restrictions, 
visitors will not be admitted beyond the immediate entrance area more 
than 15 minutes before the hearing starts. For information about having 
your name placed on the building access list to attend the hearing, see 
the FOR FURTHER INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit written 
comments and an outline of the topics to be discussed and the time to 
be devoted to each topic (signed original and eight (8) copies) by May 
30, 2001. A period of 10 minutes will be allotted to each person for 
making comments. An agenda showing the scheduling of the speakers will 
be prepared after the deadline for receiving outlines has passed. 
Copies of the agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these proposed regulations is John 
Aramburu, Office of Associate Chief Counsel (Income Tax and 
Accounting). However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. In Sec. 1.381(c)(4)-1, a sentence is added at the end of 
paragraph (a)(2) to read as follows:


Sec. 1.381(c)(4)-1  Method of accounting.

    (a) * * *
    (2) * * * See Sec. 1.460-4(k) for rules relating to transfers of 
contracts accounted for using a long-term contract method of accounting 
in a transaction to which section 381 applies.
* * * * *
    Par. 3. Section 1.460-0 is amended by:
    1. Revising the entry for paragraph (k) of Sec. 1.460-4.
    2. Adding entries for paragraphs (k)(1) through (k)(6) of 
Sec. 1.460-4.
    3. Revising the entry for paragraph (g) of Sec. 1.460-6.
    4. Adding entries for paragraphs (g)(1) through (g)(3) of 
Sec. 1.460-6.
    The revisions and additions read as follows:

Sec. 1.460-0  Outline of regulations under section 460.

* * * * *

Sec. 1.460-4  Methods of accounting for long-term contracts.

* * * * *
    (k) Mid-contract change in taxpayer.
    (1) In general.
    (2) Constructive completion transactions.
    (i) Scope.
    (ii) Old taxpayer.
    (iii) New taxpayer.
    (3) Step-in-the-shoes transactions.
    (i) Scope.
    (ii) Old taxpayer.
    (iii) New taxpayer.
    (A) Method of accounting.
    (B) Contract price.
    (C) Contract costs.
    (4) Anti-abuse rule.
    (5) Examples.
    (6) Effective date.
* * * * *

[[Page 10647]]

Sec. 1.460-6  Look-back method.

* * * * *
    (g) Mid-contract change in taxpayer.
    (1) In general.
    (2) Constructive completion transactions.
    (3) Step-in-the-shoes transactions.
    (i) General rules.
    (ii) Application of look-back method to pre-transaction period.
    (A) Method.
    (B) Interest accrual period.
    (C) Information old taxpayer must provide.
    (iii) Application of look-back method to post-transaction years.
* * * * *
    Par. 4. Section 1.460-4 is amended by:
    1. Adding a sentence at the end of paragraph (a).
    2. Revising paragraph (k).
    The revision and addition read as follows:


Sec. 1.460-4  Methods of accounting for long-term contracts.

    (a) * * * Finally, paragraph (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.
* * * * *
    (k) Mid-contract change in taxpayer--(1) In general. The rules in 
this paragraph (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 reporting income from the same contract. For 
purposes of this paragraph (k) and Sec. 1.460-6(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, and 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) of this section, while the rules governing 
step-in-the-shoes transactions are provided in paragraph (k)(3) of this 
section. For application of the look-back method to mid-contract 
changes in taxpayers for contracts accounted for using the PCM, see 
Sec. 1.460-6(g).
    (2) Constructive completion transactions--(i) Scope. The 
constructive completion rules in this paragraph (k)(2) apply to 
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) of this section (constructive completion 
transactions). Constructive completion transactions generally include, 
for example, taxable sales under section 1001 and deemed asset sales 
under section 338.
    (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 after the transaction. Total contract price (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 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 or 1060, the amount realized from 
the transaction allocable to the contract is determined by using the 
residual method under Secs. 1.338-6T and 1.338-7T.
    (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 Sec. 1.460-1(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) of this section. Total 
contract price is reduced in the amount of any consideration paid as a 
result of the transaction, and by any transaction costs, that are 
allocable to the contract and is increased in the amount of any 
consideration received 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) of this 
section, adjusted for any consideration paid (or received) as a result 
of the transaction that is allocable to the contract. Thus, the new 
taxpayer's allocable contract costs 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 or 1060, the amount of consideration paid that is 
allocable to the contract is determined by using the residual method 
under Secs. 1.338-6T and 1.338-7T.
    (3) Step-in-the-shoes transactions--(i) Scope. The step-in-the-
shoes rules in this paragraph (k)(3) apply to the following 
transactions that result in a change in the taxpayer responsible for 
reporting income from a contract (step-in-the-shoes transactions)--
    (A) Transactions described in section 381 (i.e., liquidations under 
section 332 and reorganizations described in section 368(a)(1)(A), (C), 
(D), (F), or (G));
    (B) Transactions described in section 351;
    (C) Transactions described in section 368(a)(1)(D) with respect to 
which the requirements of section 355 (or so much of section 356 as 
relates to section 355) are met;
    (D) Transfers (e.g., sales) of S corporation stock;
    (E) Conversion to or from an S corporation;
    (F) Members joining or leaving a consolidated group; and
    (G) Any other transaction designated in the Internal Revenue 
Bulletin by the Internal Revenue Service. See Sec. 601.601(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, consistent with Sec. 1.381(c)(4)-1(a)(1)(ii), 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) 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) Basis adjustment. In the case of transactions described in 
paragraph (k)(3)(i)(B) or (C) of this section, the old taxpayer must 
adjust its basis in the stock of the new taxpayer by reducing such 
basis to the extent the amount the old taxpayer has received or 
reasonably expects to receive under the contract exceeds the amount 
recognized by the old taxpayer with respect to the contract or by 
increasing such basis to the extent the amount the old taxpayer has 
recognized with respect to the contract exceeds the amount the old 
taxpayer has received or reasonably expects to receive under the 
contract. However, the old taxpayer may not reduce its basis in

[[Page 10648]]

the stock of the new taxpayer below zero. If the old and new taxpayer 
do not join in the filing of a consolidated Federal income tax return, 
the old taxpayer must recognize income to the extent the basis in the 
stock of the new taxpayer otherwise would be reduced 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 reduced below zero. See 
Secs. 1.1502-19 and 1.1502-32(a)(3)(ii).
    (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 consistent with Sec. 1.381(c)(4)-
1(b)(4). 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 Sec. 1.381(c)(4)-1(b)(3) 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, 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. The total contract price for the new taxpayer 
is the sum of any amounts the old taxpayer or new taxpayer have 
received or reasonably expect to receive under the contract consistent 
with paragraph (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 new taxpayer are entitled by 
law or by contract to receive consistent with paragraph (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) 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 are not 
treated as part of contract price or an allocable contract cost.
    (4) Anti-abuse rule. Notwithstanding this paragraph (k), in tax 
avoidance cases, the Commissioner may allocate to the old (or new) 
taxpayer the income from a long-term contract properly allocable to the 
old (or new) taxpayer. For example, the Commissioner may scrutinize a 
transaction in which a long-term 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.
    (5) Examples. The following examples illustrate the rules of this 
paragraph (k). For purposes of these examples, it is assumed that the 
contracts are long-term construction contracts accounted for using the 
PCM prior to the transaction unless stated otherwise and the contracts 
are not transferred in tax avoidance cases. The examples are as 
follows:

    Example 1. Constructive completion--PCM.
    (i) Facts. In Year 1, X enters into a contract. The total 
contract price is $1,000,000 and the estimated total allocable 
contract costs are $800,000. In Year 1, X incurs costs of $200,000. 
In Year 2, X incurs additional costs of $400,000 before selling the 
contract as part of the sale of its business in Year 2 to Y, an 
unrelated party. At the time of sale, X has received $650,000 in 
progress payments under the contract. The consideration allocable to 
the contract under section 1060 is $150,000. Pursuant to the sale, 
the new taxpayer Y immediately assumes X's contract obligations and 
rights. Y is required to account for the contract using the PCM. In 
Year 2, Y incurs additional allocable contract costs of $50,000. Y 
correctly estimates at the end of Year 2 that it will have to incur 
an additional $75,000 of allocable contract costs in Year 3 to 
complete the contract.
    (ii) Old taxpayer. For Year 1, X reports receipts of $250,000 
(the completion factor multiplied by total contract price ($200,000/
$800,000 x $1,000,000)) and costs of $200,000, for a profit of 
$50,000. X is treated as completing the contract in Year 2 because 
it sold the contract. For purposes of applying the PCM in Year 2, 
the total contract price is $800,000 (the sum of the amounts 
received under the contract and the amount realized in the sale 
($650,000 + $150,000)) and the total allocable contract costs are 
$600,000 (the sum of the costs incurred in Year 1 and Year 2 
($200,000 + $400,000)). Thus, in Year 2, X reports receipts of 
$550,000 (total contract price minus receipts already reported 
($800,000-$250,000)) and costs incurred in year 2 of $400,000, for a 
profit of $150,000.
    (iii) New taxpayer. Y is treated as entering into a new contract 
in Year 2. The total contract price is $200,000 (the amount 
remaining to be paid under the terms of the contract less the 
consideration paid allocable to the contract 
($1,000,000-$650,000-$150,000)). The estimated total allocable 
contract costs at the end of Year 2 are $125,000 (the allocable 
contract costs that Y reasonably expects to incur to complete the 
contract ($50,000 + $75,000)). In Year 2, Y reports receipts of 
$80,000 (the completion factor multiplied by the total contract 
price [($50,000/$125,000)  x  $200,000] and costs of $50,000 (the 
costs incurred after the purchase), for a profit of $30,000. For 
Year 3, Y reports receipts of $120,000 (total contract price minus 
receipts already reported ($200,000-$80,000)) and costs of $75,000, 
for a profit of $45,000.

    Example 2. Constructive completion--CCM.
    (i) Facts. The facts are the same as in Example 1, except that X 
and Y properly account for the contract under the CCM.
    (ii) Old taxpayer. X does not report any income or costs from 
the contract in Year 1. In Year 2, the contract is deemed complete 
for X, and X reports its gross contract price of $800,000 (the sum 
of the amounts received under the contract and the amount realized 
in the sale ($650,000 + $150,000)) and its total allocable contract 
costs of $600,000 (the sum of the costs incurred in Year 1 and Year 
2 ($200,000 + $400,000)) in that year.
    (iii) New taxpayer. Y is treated as entering into a new contract 
in Year 2. Under the CCM, Y reports no gross receipts or costs in 
Year 2. Y reports its gross contract price of $200,000 (the amount 
remaining to be paid under the terms of the contract less the 
consideration paid allocable to the contract 
($1,000,000-$650,000-$150,000)) and its total allocable contract 
costs of $125,000 (the allocable contract costs that Y incurred to 
complete the contract ($50,000 + $75,000)) in Year 3, the completion 
year, for a profit of $75,000.

    Example 3. Step-in-the-shoes--PCM.
    (i) Facts. The facts are the same as in Example 1, except that X 
transfers the contract to Y in exchange for stock of Y in a 
transaction that qualifies as a statutory merger described in 
section 368(a)(1)(A) and does not result in gain or loss to X under 
section 361(a).
    (ii) Old taxpayer. For Year 1, X reports receipts of $250,000 
(the completion factor multiplied by total contract price ($200,000/
$800,000  x  $1,000,000)) and costs of $200,000, for a profit of 
$50,000. Because the mid-contract change in taxpayer results from a 
transaction described in paragraph (k)(3)(i) of this section, X is 
not treated as completing the contract in Year 2. In Year 2, X 
reports receipts of $500,000 (the completion factor multiplied by 
the total contract price and minus the Year 1 gross receipts 
[($600,000/

[[Page 10649]]

$800,000  x  $1,000,000) - $250,000]) and costs of $400,000, for a 
profit of $100,000.
    (iii) New taxpayer. Because the mid-contract change in taxpayer 
results from a step-in-the-shoes transaction, Y must account for the 
contract using the same methods of accounting used by X prior to the 
transaction. Total contract price is the sum of any amounts that X 
and Y have received or reasonably expect to receive under the 
contract, and total allocable contract costs are the allocable 
contract costs of X and Y. Thus, the estimated total allocable 
contract costs at the end of Year 2 are $725,000 (the cumulative 
allocable contract costs of X and the estimated total allocable 
contract costs of Y ($200,000 + $400,000 + $50,000 + $75,000)). In 
Year 2, Y reports receipts of $146,552 (the completion factor 
multiplied by the total contract price minus receipts reported by 
the old taxpayer ([($650,000/$725,000)  x  $1,000,000]-$750,000) and 
costs of $50,000, or a profit of $96,552. For Year 3, Y reports 
receipts of $103,448 (the total contract price minus prior year 
receipts ($1,000,000-$896,552)) and costs of $75,000, for a profit 
of $28,448.

    Example 4. Step-in-the-shoes--CCM.
    (i) Facts. The facts are the same as in Example 3, except that X 
properly accounts for the contract under the CCM.
    (ii) Old taxpayer. X reports no income or costs from the 
contract in Years 1, 2 or 3.
    (iii) New taxpayer. Because the mid-contract change in taxpayer 
results from a step-in-the-shoes transaction, Y must account for the 
contract using the same methods of accounting used by X prior to the 
transaction. Thus, in Year 3, the completion year, Y reports 
receipts of $1,000,000 and total contract costs of $725,000, for a 
profit of $275,000.

    Example 5. Step in the shoes--Basis adjustment.
    The facts are the same as in Example 1, except that X transfers 
the contract (including the uncompleted property with a basis of $0) 
and $125,000 of cash to a new corporation, Z, in exchange for all of 
the stock of Z in a section 351 transaction. Thus, under section 
358(a), X's basis in Z is $125,000. X must increase its basis in Z 
by $100,000 pursuant to paragraph (k)(3)(ii)(B) of this section 
because the amount X recognized with respect to the contract, 
$750,000 ($250,000 receipts in Year 1 + $500,000 receipts in Year 
2), exceeds the amount X received under the contract, the $650,000 
in progress payments, by $100,000.

    Example 6. Step in the shoes--Basis adjustment.
    The facts are the same as in Example 2, except that X receives 
progress payments of $800,000 (rather than $650,000) and transfers 
the contract (including the uncompleted property with a basis of 
$600,000) and $125,000 of cash to a new corporation, Z, in exchange 
for all of the stock of Z in a section 351 transaction. Thus, under 
section 358(a), X's basis in Z is $725,000. X and Z do not join in 
filing a consolidated Federal income tax return. X must reduce its 
basis in the stock of Z by $725,000 to zero pursuant to paragraph 
(k)(3)(ii)(B) of this section because the amount X received under 
the contract, $800,000 in progress payments, exceeds the amount 
recognized by X with respect to the contract, $0. In addition, X 
must recognize income of $75,000 because X's basis in the stock of Z 
otherwise would have been reduced below zero by $75,000 (800,000 
unrecognized progress payments--725,000 basis).

    (6) Effective date. This paragraph (k) is applicable for 
transactions on or after the date they are published in the Federal 
Register as final regulations.
    Par. 5. In Sec. 1.460-6, paragraph (g) is revised to read as 
follows:


Sec. 1.460-6  Look-back method.

* * * * *
    (g) Mid-contract change in taxpayer--(1) In general. The rules in 
this paragraph (g) apply if, as described in Sec. 1.460-4(k), prior to 
the completion of a long-term contract accounted for using the PCM or 
the PCCM by a taxpayer (old taxpayer), there is a transaction that 
makes another taxpayer (new taxpayer) responsible for reporting income 
from the same contract. The rules governing constructive completion 
transactions are provided in paragraph (g)(2) of this section, while 
the rules governing step-in-the-shoes transactions are provided in 
paragraph (g)(3) of this section. For purposes of this paragraph, pre-
transaction years are all taxable years of the old taxpayer in which 
the old taxpayer reported (or should have reported) gross receipts from 
the contract, and post-transaction years are all taxable years of the 
new taxpayer in which the new taxpayer reported (or should have 
reported) gross receipts from the contract.
    (2) Constructive completion transactions. In the case of a 
transaction described in Sec. 1.460-4(k)(2)(i) (constructive completion 
transaction), the look-back method is applied by the old taxpayer with 
respect to pre-transaction years upon the date of the transaction and, 
if the new taxpayer uses the PCM or the PCCM to account for the 
contract, by the new taxpayer with respect to post-transaction years 
upon completion of the contract. The contract price and allocable 
contract costs to be taken into account by the old taxpayer or the new 
taxpayer in applying the look-back method are described in Sec. 1.460-
4(k)(2).
    (3) Step-in-the-shoes transactions--(i) General rules. In the case 
of a transaction described in Sec. 1.460-4(k)(3)(i) (step-in-the-shoes 
transaction), the look-back method is not applied at the time of the 
transaction, but is instead applied for the first time when the 
contract is completed by the new taxpayer. Upon completion of the 
contract, the look-back method is applied by the new taxpayer with 
respect to both pre-transaction years and post-transaction years, 
taking into account all amounts reasonably expected to be received by 
either the old or new taxpayer and all allocable contract costs 
incurred during both periods as described in Sec. 1.460-4(k)(3). The 
new taxpayer is liable for filing the Form 8697 and for interest 
computed on hypothetical underpayments of tax, and is entitled to 
receive interest with respect to hypothetical overpayments of tax, for 
both pre-and post-transaction years. Pursuant to section 6901, the old 
taxpayer will be secondarily liable for any interest required to be 
paid with respect to pre-transaction years reduced by any interest on 
pre-transaction overpayments.
    (ii) Application of look-back method to pre-transaction period--(A) 
Method. The new taxpayer must apply the look-back method to each pre-
transaction year that is a redetermination year using the simplified 
marginal impact method described in paragraph (d) of this section 
(regardless of whether or not the old taxpayer would have actually used 
that method and without regard to the tax liability ceiling).
    (B) Interest accrual period. With respect to any hypothetical 
underpayment or overpayment of tax for a pre-transaction year, interest 
accrues from the due date of the old taxpayer's tax return (not 
including extensions) for the taxable year of the underpayment or 
overpayment until the due date of the new taxpayer's return (not 
including extensions) for the completion year or the year of a post-
completion adjustment, whichever is applicable.
    (C) Information old taxpayer must provide. In order to help the new 
taxpayer to apply the look-back method with respect to pre-transaction 
taxable years, any old taxpayer that reported income from a long-term 
contract under the PCM or PCCM for either regular or alternative 
minimum tax purposes is required to provide the information described 
in this paragraph to the new taxpayer by the due date (not including 
extensions) of the old taxpayer's income tax return for the taxable 
year ending with, or the first taxable year ending after, a step-in-
the-shoes transaction described in Sec. 1.460-4(k)(3)(i). The required 
information is as follows--
    (1) The portion of the contract reported by the old taxpayer under 
PCM for regular and alternative minimum tax purposes (i.e., whether the 
old taxpayer used PCM, the 40/60 PCCM method, or the 70/30 PCCM 
method);
    (2) The submethod used to apply PCM (e.g., the simplified cost-to-
cost method or the 10-percent method);

[[Page 10650]]

    (3) The amount of total contract price reported by year;
    (4) The numerator and the denominator of the completion factor by 
year;
    (5) The due date (not including extensions) of the old taxpayer's 
income tax returns for each taxable year in which income was required 
to be reported;
    (6) Whether the old taxpayer was a corporate or a noncorporate 
taxpayer by year; and
    (7) Any other information required by the Commissioner by 
administrative pronouncement.
    (iii) Application of look-back method to post-transaction years. 
With respect to post-transaction taxable years, the new taxpayer must 
use the same look-back method it uses for other contracts (i.e., the 
simplified marginal impact method or the actual method) to determine 
the amount of any hypothetical overpayment or underpayment of tax and 
the time period for computing interest on these amounts.
* * * * *

David A. Mader,
Acting Deputy Commissioner of Internal Revenue.
[FR Doc. 01-1992 Filed 2-15-01; 8:45 am]
BILLING CODE 4830-01-P