[Federal Register Volume 68, Number 151 (Wednesday, August 6, 2003)]
[Proposed Rules]
[Pages 46516-46526]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-18484]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-128203-02]
RIN 1545-BA81


Partnership Transactions Involving Long-Term Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations relating to 
partnership transactions involving contracts accounted for under a 
long-term contract method of accounting. The regulations are necessary 
to resolve issues that were reserved in final regulations under section 
460 that were published in the Federal Register on May 15, 2002, 
addressing other mid-contract changes in taxpayer engaged in completing 
such contracts. The effect of the regulations is to explain the tax 
consequences of these partnership transactions.

DATES: Written and electronic comments and requests for a public 
hearing must be received by November 4, 2003.

ADDRESSES: Send submissions to: CC:PA:RU (REG-128203-02), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered Monday through Friday 
between the hours of 8 a.m. and 4 p.m.

[[Page 46517]]

to: CC:PA:RU (REG-128203-02), Courier's Desk, Internal Revenue Service, 
1111 Constitution Avenue, NW., Washington, DC. Alternatively, taxpayers 
may submit comments electronically via the internet directly to the IRS 
Internet site at http://www.irs.gov/regs.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Richard 
Probst, (202) 622-3060; concerning submissions, Guy Traynor, (202) 622-
7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION 

Background

    Section 460 of the Internal Revenue Code generally requires that 
taxpayers determine taxable income from a long-term contract using the 
percentage-of-completion method (PCM). Under regulations finalized in 
2001 (TD 8929, 2001-1 C.B. 756), a taxpayer using the PCM generally 
includes a portion of the total contract price in income for each 
taxable year that the taxpayer incurs contract costs allocable to the 
long-term contract. More specifically, to determine the income from a 
long-term contract, the taxpayer first computes the completion factor 
for the contract, which is the percentage of the estimated total 
allocable contract costs that the taxpayer has incurred (based on the 
all events test of section 461, including economic performance, 
regardless of the taxpayer's method of accounting) through the end of 
the taxable year. Second, the taxpayer computes the amount of 
cumulative gross receipts from the contract by multiplying the 
completion factor by the total contract price, which is the amount that 
the taxpayer reasonably expects to receive under the contract. Third, 
the taxpayer computes the amount of current-year gross receipts, which 
is the difference between the cumulative gross receipts for the current 
taxable year and the cumulative gross receipts for the immediately 
preceding taxable year. This difference may be a loss (a negative 
number) based on revisions to estimates of total allocable contract 
costs or total contract price. Fourth, the taxpayer takes into account 
both the current-year gross receipts and the amount of allocable 
contract costs actually incurred during the taxable year. To the extent 
any portion of the total contract price has not been included in 
taxable income by the completion year, section 460(b)(1) and the 
regulations require the taxpayer to include that portion in income for 
the taxable year following the completion year.
    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). Under the CCM, a 
taxpayer does not take into account the gross contract price and 
allocable contract costs until the contract is complete, even though 
progress payments are received in years prior to completion.
    A taxpayer generally must allocate costs to a contract subject to 
section 460(a) in the same manner as direct and indirect costs are 
capitalized to property produced by a taxpayer under section 263A. The 
regulations provide exceptions, however, that reflect the differences 
in the cost allocation rules of sections 263A and 460.
    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.
    On May 15, 2002, final regulations under section 460 were issued to 
address a mid-contract change in taxpayer engaged in completing a 
contract accounted for under a long-term contract method of accounting 
(TD 8995; 2002-23 I.R.B. 1070). The regulations divide the rules 
regarding a mid-contract change in taxpayer into two categories-
constructive completion transactions and step-in-the-shoes 
transactions.
    In a constructive completion transaction, the taxpayer that 
originally accounted for the long-term contract (old taxpayer) must 
recognize income from the contract as of the time of the transaction. 
The contract price used to determine the amount of income recognized by 
the taxpayer is the amount realized from the transaction, reduced by 
any amounts paid by the old taxpayer to the taxpayer subsequently 
accounting for 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. The new taxpayer's contract 
price is the amount that the new taxpayer reasonably expects to receive 
under the contract, reduced by the price paid by the new taxpayer for 
the contract, and increased by any amounts paid by the old taxpayer to 
the new taxpayer that are allocable to the contract. In contrast, in 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.
    The final section 460 regulations provide that a contribution to a 
partnership in a transaction described in section 721(a), a transfer of 
a partnership interest, and a distribution by a partnership to which 
section 731 applies (other than a distribution of a contract accounted 
for under a long-term contract method of accounting) are step-in-the-
shoes transactions. In a notice issued concurrently with the final 
regulations, Notice 2002-37 (2002-23 I.R.B. 1095), Treasury and the IRS 
announced their intention to publish regulations setting forth the 
special rules that apply to these partnership transactions and 
described many of these rules. The notice further provided that these 
regulations would apply to contributions, transfers, and distributions 
occurring on or after May 15, 2002. The IRS requested comments as to 
the appropriate scope and substance of the regulations. No comments 
were received.

Explanation and Summary of Contents

1. Contribution of a Contract to a Partnership

    The final section 460 regulations provide that a contribution of a 
contract accounted for under a long-term contract method of accounting 
in a transaction described in section 721(a) is a step-in-the-shoes 
transaction. Under section 722, the partner's basis in the partnership 
interest is increased by the adjusted basis of the contributed contract 
(including the uncompleted property, if applicable). Under section 723, 
the partnership's basis in the contributed contract (including the 
uncompleted property, if applicable) equals the partner's basis in the 
contributed contract (including the uncompleted property, if 
applicable).
    Under the final section 460 regulations, the basis of a long-term 
contract (including the uncompleted property, if applicable) is 
determined by reference to the allocable contract costs incurred by the 
taxpayer but not taken into account in computing taxable income. Thus, 
if the contract is accounted for under the PCM, then the taxpayer's 
basis in the contract is $0, even though the taxpayer has incurred 
costs and recognized income under the contract. If, on the other hand, 
the contract is accounted for under the CCM, then the taxpayer's basis 
in the contract is equal to the costs incurred by the taxpayer, 
unreduced by any progress

[[Page 46518]]

payments that the taxpayer has received but not taken into income with 
respect to the contract. Under these rules, a partner accounting for a 
long-term contract under the CCM that incurs $400 of allocable contract 
costs, receives $500 of progress payments with respect to the contract, 
and the contributes the contract, but not the progress payments, to a 
partnership would be able to claim a $400 basis in the partnership 
interest received. Without any adjustments, such an analysis would give 
rise to erroneous results.
    For this reason, these proposed regulations, like the rules in the 
final section 460 regulations applicable to corporate step-in-the-shoes 
transactions, such as transactions described in section 351(a), require 
a partner that contributes a contract accounted for under a long-term 
contract method of accounting to a partnership to adjust the basis of 
the partnership interest received. Specifically, the proposed 
regulations require the partner to increase the basis of the 
partnership interest by the amount of gross receipts that the partner 
has recognized under the contract, and reduce the basis of the 
partnership interest by the amount of gross receipts the partner has 
received or reasonably expects to receive under the contract. If the 
decrease exceeds the partner's basis in the partnership interest, then 
the partner must recognize income equal to the excess. To ensure that 
the partnership is not taxed again on any income taken into account by 
the partner under this rule, the proposed regulations require the 
partnership to reduce its total contract price (or gross contract 
price) by the amount of income recognized by the contributing partner.

2. Built-In Income and Loss

    Section 704(c) generally provides that income, gain, loss, or 
deduction attributable to property that is contributed to a partnership 
must be allocated to the contributing partner. The purpose of section 
704(c) is to prevent the shifting of tax consequences among partners 
with respect to precontribution gain or loss. These proposed 
regulations provide that the principles of section 704(c) and Sec.  
1.704-3 apply to allocations of income or loss with respect to a 
contract accounted for under a long-term contract method of accounting 
that is contributed to a partnership (or that is revalued by a 
partnership under Sec.  1.704-1(b)(2)(iv)(f)). The proposed regulations 
provide that the partnership must apply section 704(c) to such income 
or loss in a manner that reasonably accounts for the section 704(c) 
income or loss over the remaining term of the contract.
    Under the proposed regulations, the amount of built-in income or 
built-in loss attributable to a contributed contract that is subject to 
section 704(c) is determined as follows. First, the contributing 
partner must take into account any income or loss required under the 
step-in-the-shoes rules for the period ending on the date of the 
contribution. Second, the partnership determines 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 the step-in-the-shoes rules, 
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.

3. Transfer of a Partnership Interest

    The transfer of an interest in a partnership engaged in a contract 
accounted for under a long-term contract method of accounting is a 
step-in-the-shoes transaction. Section 741 provides that gain or loss 
recognized on the sale or exchange of an interest in a partnership is 
considered as gain or loss from a capital asset, except as provided in 
section 751. Section 751(a) provides that the amount of any money, or 
the fair market value of any property, received by a transferor partner 
in exchange for all or any part of the partner's interest in the 
partnership attributable to unrealized receivables (as defined in 
section 751(c)) or inventory items (as defined in section 751(d)) of 
the partnership shall be considered as an amount realized from the sale 
or exchange of property other than a capital asset. In Rev. Rul. 79-51 
(1979-1 C.B. 225), the IRS addressed a transaction in which a partner 
sold the partner's entire interest in a partnership holding partially 
completed contracts, the income from which was being accounted for 
under the CCM. The IRS ruled that the value of the contracts at the 
time of sale are unrealized receivables for purposes of section 751(c).
    Consistent with Rev. Rul. 79-51, the proposed regulations provide 
that contracts accounted for under a long-term contract method of 
accounting are unrealized receivables within the meaning of section 
751(c). The amount of ordinary income or loss attributable to a 
contract is the amount of income or loss that the partnership would 
take into account under the constructive completion rules if, at the 
time of a transfer of a partnership interest, the partnership disposed 
of the contract for its fair market value in a constructive completion 
transaction.

4. Adjustments to the Basis of Partnership Property

    Section 743(b) allows a partnership to adjust the basis of 
partnership property in the case of a transfer of an interest in the 
partnership by sale or exchange or on the death of a partner. If all or 
part of a basis adjustment under section 743(b) is allocated to a 
contract accounted for under a long-term contract method of accounting, 
the proposed regulations provide that the adjustment shall reduce or 
increase, as the case may be, the transferee partner's distributive 
share of 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 the 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. Similar rules apply if all or 
part of an adjustment to the basis of partnership property under 
section 734(b) is allocated to a contract accounted for under a long-
term contract method of accounting.

5. Closing of the Books

    Generally, under the step-in-the-shoes rules, an old taxpayer's 
obligation to account for the contract terminates on the date of the 
transaction and is assumed by the new taxpayer. 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. This rule differs from Sec.  1.706-
1(c)(2)(ii), which provides that, if a partner's interest in the 
partnership terminates during the taxable year, the partnership may 
determine the partner's distributive share of partnership items either 
by closing the partnership's books as of the termination date or by 
prorating the partnership's income for the entire year between the pre- 
and post-termination periods.
    Consistent with Sec.  1.706-1(c)(2)(ii), these regulations 
generally provide that upon the transfer or liquidation of an interest 
in a partnership holding a contract accounted for under a long-term 
contract method of accounting, the step-in-the-shoes rules apply to a

[[Page 46519]]

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. If the partnership's books are not 
closed with respect to the contract, 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 transfer or liquidation as though no change in taxpayer had 
occurred with respect to that contract, and may pro rate income from 
the contract under a reasonable method complying with section 706. 
Similar rules are provided for distributions of property (other than a 
contract accounted for under a long-term contract method of accounting) 
from a partnership holding a long-term contract, and for contributions 
of property (other than a contract accounted for under a long-term 
contract method of accounting) to a partnership holding a contract 
accounted for under a long-term contract method of accounting.
    Comments are requested regarding whether similar rules should be 
provided with respect to transfers of stock in an S corporation holding 
a contract accounted for under a long-term contract method of 
accounting. See section 1377(a)(1) and Sec.  1.1377-1(a) (providing 
that each shareholder's pro rata share of any S corporation item for 
any taxable year is generally the sum of the amounts determined with 
respect to the shareholder by assigning an equal portion of the item to 
each day of the S corporation's taxable year, and then dividing that 
portion pro rata among the shares outstanding on that day); and section 
1377(a)(2) and Sec.  1.1377-1(b) (providing that an S corporation may 
elect to close its books if a shareholder's entire interest in an S 
corporation is terminated during the S corporation's taxable year, and 
the corporation and all affected shareholders agree).

6. Look-Back Method

    The final section 460 regulations generally require any old 
taxpayer that accounted for income from a long-term contract under the 
PCM, and that transfers the contract to a new taxpayer in a step-in-
the-shoes transaction, to provide the information described in Sec.  
1.460-6(g)(3)(ii)(D) to the new taxpayer. The proposed regulations 
provide that, if the step-in-the-shoes transaction is a contribution of 
property (other than a contract accounted for under a long-term 
contract method of accounting) to a partnership, the distribution of 
property (other than a contract accounted for under a long-term 
contract method of accounting) by a partnership, or a transfer of a 
partnership interest, the old taxpayer is not required to provide this 
information, because information necessary for the new taxpayer to 
apply the look-back method is provided by the partnership. A similar 
exception is provided if the step-in-the-shoes transaction is a 
transfer of stock in an S corporation, or a conversion to or from an S 
corporation.

7. Distribution of a Contract by a Partnership

    The distribution of a contract accounted for under a long-term 
contract method of accounting by a partnership to a partner is a 
constructive completion transaction. The proposed regulations provide 
that, in determining the partnership's income on the constructive 
completion transaction, the fair market value of the contract is 
treated as the amount realized from the transaction. The proposed 
regulations also clarify that, 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 partnership as though the partnership closed its books 
on the date of the distribution.
    Section 732 determines the basis of property (other than money) 
distributed by a partnership to a partner. Section 734(b) provides for 
an adjustment to the basis of partnership property as a result of 
certain distributions from partnerships that have a section 754 
election in effect. The proposed regulations provide that, if a 
contract accounted for under a long-term contract method of accounting 
is distributed to a partner, then, for purposes of determining the 
partner's basis in the contract (including the uncompleted property, if 
applicable) under section 732 and the amount of any basis adjustment 
under section 734(b), the partnership's basis in the contract 
(including the uncompleted property, if applicable) immediately prior 
to the distribution is the partnership's allocable contract costs 
(including transaction costs), 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 decreased 
by the amounts that the partnership has received or reasonably expects 
to receive under the contract.
    The proposed regulations provide that, if a contract accounted for 
under a long-term contract method of accounting is distributed to a 
partner, then, in computing the total contract price (or gross contract 
price) for the new contract, the partner's basis in the contract 
(including the uncompleted property, if applicable) after the 
distribution (as determined under section 732) is treated as 
consideration paid by the partner 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.
    Section 751(b)(1) provides that, to the extent a partner receives 
in a distribution partnership property which is unrealized receivables 
or inventory items which have appreciated substantially in value, in 
exchange for all or a part of the partner's interest in other 
partnership property (including money), the transaction is considered a 
sale or exchange of the property between the distributee partner and 
the partnership. The same treatment applies if a partner receives in a 
distribution partnership property (including money) other than 
unrealized receivables and substantially appreciated inventory in 
exchange for the partner's interest in the partnership's unrealized 
receivables or substantially appreciated inventory. 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) may apply to the distribution. Therefore, the proposed 
regulations provide an ordering rule under which a partnership that 
distributes a contract accounted for under a long-term contract method 
of accounting to apply the constructive completion rules before 
applying the rules of section 751(b) to the distribution.

8. Treatment of Progress Payments Under Section 752

    In Rev. Rul. 73-301 (1973-2 C.B. 215), the IRS addressed whether 
unrestricted progress payments received by a partnership reporting its 
income under the CCM constitute a partnership liability under section 
752. In that revenue ruling, the partnership performed all of the 
services required to be entitled to receive the progress payments, and 
there was no obligation to return the payments or perform any 
additional services in order to retain the payments. The IRS ruled that 
the progress payments described in the ruling did not constitute a 
liability

[[Page 46520]]

within the meaning of section 752. See also Rev. Rul. 81-241 (1981-2 
C.B. 146) (citing and following Rev. Rul. 73-301). Treasury and the IRS 
request comments regarding whether there are circumstances under which 
the receipt of progress payments under a contract accounted for under a 
long-term contract method of accounting could give rise to a liability 
under section 752, and, if so, how the regulations would need to be 
revised to account for such liabilities.

Proposed Effective Date

    As indicated in Notice 2002-37, the regulations are proposed to 
apply to contributions, transfers, and distributions that occur on or 
after May 15, 2002.

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, and because 
the regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, this 
notice of proposed rulemaking has been submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on its 
impact on small businesses.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight copies) that are submitted timely to the IRS. Alternatively, 
taxpayers may submit comments electronically directly to the IRS 
Internet site at http://www.irs.gov/regs. Treasury and the IRS request 
comments on the clarity of the proposed rules and how they can be made 
easier to understand. All comments will be available for public 
inspection and copying.
    A public hearing may be scheduled if requested in writing by any 
person that timely submits written comments. If a public hearing is 
scheduled, notice of the date, time, and place for the hearing will be 
published in the Federal Register.

Drafting Information

    The principal authors of these proposed regulations are Matthew Lay 
and Richard Probst of the Office of the Associate Chief Counsel 
(Passthroughs and Special Industries). However, personnel from other 
offices of Treasury and the IRS 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. Section 1.460-0 is amended as follows:
    1. Revising the entry for paragraph 1.460-4(k)(2)(iv).
    2. Adding entries for Sec.  1.460-4(k)(2)(iv)(A) through (E).
    3. Revising the entry for Sec.  1.460-4(k)(3)(iv).
    4. Revising the entry for Sec.  1.460-4(k)(3)(iv)(A)(2) and adding 
an entry for Sec. 1.460-4(k)(3)(iv)(c).
    5. Revising the entry for Sec.  1.460-4(k)(3)(v).
    6. Adding entries for Sec.  1.460-4(k)(3)(v)(A) through (D).
    7. Adding entries for Sec.  1.460-6(g)(3)(ii)(D)(1) and (2).
    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) * * *
    (2) * * *
    (iv) Special rules relating to distributions of certain contracts 
by a partnership.
    (A) In general.
    (B) Old taxpayer.
    (C) New taxpayer.
    (D) Basis rules.
    (E) Section 751.
    (1) In general.
    (2) Ordering rules.
    (3) * * *
    (iv) Special rules related to certain corporate and partnership 
transactions.
    (A) * * *
    (2) Basis adjustment in excess of stock or partnership interest 
basis.
* * * * *
    (C) Definition of old taxpayer and new taxpayer for certain 
partnership transactions.
    (v) Special rules relating to certain partnership transactions.
    (A) Section 704(c).
    (1) Contributions of contracts.
    (2) Revaluations of partnership property.
    (3) Allocation methods.
    (B) Basis adjustments under sections 743(b) and 734(b).
    (C) Cross reference.
    (D) Exceptions to step-in-the-shoes rules.
* * * * *


Sec.  1.460-6  Look-back method.

* * * * *
    (g) * * *
    (3) * * *
    (ii) * * *
    (D) * * *
    (1) In general.
    (2) Special rules for certain pass-through entity transactions.
* * * * *
    Par. 3. Section 1.460-4 is amended as follows:
    1. Revising the sixth sentence in paragraph (k)(1).
    2. Revising paragraph (k)(2)(iv).
    3. Removing the first word ``The'' in paragraph (k)(3)(i) and 
adding in its place: ``Except as otherwise provided in paragraph 
(k)(3)(v)(D) of this section, the''
    4. Revising paragraph (k)(3)(i)(I).
    5. Redesignating paragraphs (k)(3)(i)(J), (K) and (L) as paragraphs 
(k)(3)(i)(K), (L) and (M), respectively.
    6. Adding a new paragraph (k)(3)(i)(J).
    7. Revising paragraph (k)(3)(iv).
    8. Adding text to paragraph (k)(3)(v).
    9. Adding to paragraph (k)(5) Example 9 through Example 13.
    The additions and revisions read as follows.


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

* * * * *
    (k) * * *
    (1) * * * Special rules relating to the treatment of certain 
partnership transactions are provided in paragraphs (k)(2)(iv) and 
(k)(3)(v) of this section. * * *
    (2) * * *
    (iv) Special rules relating to distributions of certain contracts 
by a partnership--(A) In general. The constructive completion rules of 
paragraph (k)(2) of this section apply to the distribution of a 
contract accounted for under a long-term contract method of accounting 
by a partnership to a partner. The constructive completion rules of 
paragraph (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

[[Page 46521]]

second partnership (transferee partnership) in an exchange described in 
section 721, followed by a distribution of the interest in the 
transferee partnership in liquidation of the transferor partnership, 
under Sec.  1.708-1(b)(4) (relating to terminations under section 
708(b)(1)(B)) or Sec.  1.708-1(c)(3)(i) (relating to certain 
partnership mergers).
    (B) Old taxpayer. The partnership that distributes the contract is 
treated as the old taxpayer for purposes of paragraph (k)(2)(ii) of 
this section. For purposes of determining the total contract price (or 
gross contract price) under paragraph (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) of 
this section. For purposes of determining the total contract price (or 
gross contract price) under paragraph (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) 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, and the amount of any basis adjustment 
under section 734(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). For purposes of section 751, 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) 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 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) 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) of this section before applying the rules of 
section 751(b) to the distribution.
* * * * *
    (3) * * *
    (i) * * *
    (I) Contributions of contracts accounted for under a long-term 
contract method of accounting to which section 721(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;
* * * * *
    (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), (E), or 
(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.
    (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 
Sec. Sec.  1.1502-19 and 1.1502-32(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), (E), or (I) of this section that the old taxpayer 
acquired in a transaction described in paragraph (k)(3)(i)(D), (E), or 
(I) of this section, the basis adjustment rule of this paragraph 
(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), (E), or (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) of this section, however, in the case of transactions 
described in paragraph (k)(3)(i)(B), (D), (E), or (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) or section 357 that is attributable to 
the contract and any income recognized by the old taxpayer pursuant

[[Page 46522]]

to the basis adjustment rule of paragraph (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) or 
paragraph (k)(3)(i)(I) of this section will be computed under section 
362, section 334, or section 723, 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) or 
paragraph (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), (iii) 
and (iv) of this section, in the case of a transaction described in 
paragraph (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.
    (v) Special rules relating to certain partnership transactions--(A) 
Section 704(c)--(1) Contributions of contracts. The principles of 
sections 704(c) and Sec.  1.704-3 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) is determined as follows. First, the 
contributing partner must take into account any income or loss required 
under paragraph (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) 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) and Sec.  1.704-3 apply to allocations of income or loss with 
respect to a long-term contract that is revalued by a partnership under 
Sec.  1.704-1(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, immediately before 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) 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) must be taken into account in a manner that reasonably 
accounts for the section 704(c) income or loss over the remaining term 
of the contract.
    (B) Basis adjustments under sections 743(b) and 734(b). For 
purposes of Sec. Sec.  1.743-1(d), 1.755-1(b), and 1.755-1(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) 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) or the 
partnership's basis adjustment under section 734(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) of this section 
for rules relating to the application of section 751 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) of this section, a transfer 
described in paragraph (k)(3)(i)(K) of this section, or a distribution 
described in paragraph (k)(3)(i)(L) of this section, paragraphs 
(k)(3)(ii) and (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. In these cases, the partnership is treated as both 
the old taxpayer and the new taxpayer for purposes of paragraphs 
(k)(3)(ii) and (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.
* * * * *
    (5) * * *

    Example 9. Constructive completion--PCM--distribution of 
contract by partnership--(i) Facts.  In Year 1, W, X, Y, and Z each 
contribute $100,000 to form equal partnership PRS. In Year 1, PRS 
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, PRS incurs costs of $600,000 and receives $650,000 in progress 
payments under the contract. Under the contract, PRS performed all 
of the services required in order to be entitled to receive the 
progress payments, and there was no obligation to return the 
payments or perform any additional services in order to retain the 
payments. PRS properly accounts for the contract under the PCM. In 
Year 2, PRS distributes the contract to X in liquidation of X's 
interest. PRS incurs no costs and receives no progress payments in 
Year 2 prior to the distribution. At the time of the distribution, 
PRS's only asset other than the long-term contract and the partially 
constructed property is $450,000 cash ($400,000 initially 
contributed and $50,000 in excess progress payments). The fair 
market value of the contract is $150,000. Pursuant to the 
distribution, X assumes PRS's contract obligations and rights. In 
Year 2, X incurs additional allocable contract costs of $50,000. X 
correctly estimates at the end of Year 2 that X will have to incur 
an additional $75,000 of allocable contract costs in Year 3 to 
complete the contract (rather than $150,000 as originally estimated 
by PRS). Assume that X properly accounts for the contract under the 
PCM, that PRS has no income or loss other than income or loss from 
the contract, and that PRS has an election under section 754 in 
effect in Year 2.
    (ii) Tax consequences to PRS. For Year 1, PRS reports receipts 
of $750,000 (the completion factor multiplied by total contract

[[Page 46523]]

price ($600,000/$800,000 x $1,000,000)) and costs of $600,000, for a 
profit of $150,000, which is allocated equally among W, X, Y, and Z 
($37,500 each). Immediately prior to the distribution of the 
contract to X in Year 2, the contract is deemed completed. Under 
paragraph (k)(2)(iv)(B) of this section, the fair market value of 
the contract ($150,000) is treated as the amount realized from the 
transaction. 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 treated as realized from the transaction 
($650,000 + $150,000)) and the total allocable contract costs are 
$600,000. Thus, in Year 2 PRS reports receipts of $50,000 (total 
contract price minus receipts already reported ($800,000--
$750,000)), and costs incurred in year 2 of $0, for a profit of 
$50,000. Under paragraph (k)(2)(iv)(B) of this section, this profit 
must be allocated among W, X, Y, and Z as though the partnership 
closed its books on the date of the distribution. Accordingly, each 
partner's distributive share of this income is $12,500.
    (iii) Tax consequences to X. X's basis in its interest in PRS 
immediately prior to the distribution is $150,000 (X's $100,000 
initial contribution, increased by $37,500, X's distributive share 
of Year 1 income, and $12,500, X's distributive share of Year 2 
income). Under paragraph (k)(2)(iv)(D) of this section, PRS's basis 
in the contract (including the uncompleted property, if applicable) 
immediately prior to the distribution is equal to $150,000 (the 
partnership's allocable contract costs, $600,000, increased by the 
amount of income recognized by PRS on the contract through the date 
of the distribution (including amounts recognized as a result of the 
constructive completion), $200,000, decreased by the amounts that 
the partnership has received or reasonably expects to receive under 
the contract, $650,000). Under section 732, X's basis in the 
contract (including the uncompleted property) after the distribution 
is $150,000. Under paragraph (k)(2)(iv)(C) of this section, X's 
basis in the contract (including the uncompleted property) is 
treated as consideration paid by X that is allocable to the 
contract. X's total contract price is $200,000 (the amount remaining 
to be paid under the terms of the contract less the consideration 
allocable to the contract ($350,000--$150,000)). For Year 2, X 
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 distribution of the contract), 
for a profit of $30,000. For Year 3, X reports receipts of $120,000 
(the total contract price minus receipts already reported 
($200,000--$80,000)) and costs of $75,000, for a profit of $45,000.
    (iv) Section 734(b). Because X's basis in the contract 
(including the uncompleted property) immediately after the 
distribution, $150,000, is equal to PRS's basis in the contract 
(including the uncompleted property) immediately prior to the 
distribution, a basis adjustment under section 734(b) is not 
required.
    Example 10. Constructive completion--CCM--distribution of 
contract by partnership--(i) Facts.  The facts are the same as in 
Example 9, except that PRS and X properly account for the contract 
under the CCM.
    (ii) Tax consequences to PRS. PRS reports no income or costs from 
the contract in Year 1. Immediately prior to the distribution of the 
contract to X in Year 2, the contract is deemed completed. Under 
paragraph (k)(2)(iv)(B) of this section, the fair market value of the 
contract ($150,000) is treated as the amount realized from the 
transaction. For purposes of applying the CCM in Year 2, the gross 
contract price is $800,000 (the sum of the amounts received under the 
contract and the amount treated as realized from the transaction 
($650,000 + $150,000)) and the total allocable contract costs are 
$600,000. Thus, in Year 2 PRS reports profits of $200,000 ($800,000-
$600,000). This profit must be allocated among W, X, Y, and Z as though 
the partnership closed its books on the date of the distribution. 
Accordingly, each partner's distributive share of this income is 
$50,000.
    (iii) Tax consequences to X. X's basis in its interest in PRS 
immediately prior to the distribution is $150,000 ($100,000 initial 
contribution, increased by $50,000, X's distributive share of Year 2 
income). Under paragraph (k)(2)(iv)(D) of this section, PRS's basis in 
the contract (including the uncompleted property, if applicable) 
immediately prior to the distribution is equal to $150,000 (the 
partnership's allocable contract costs, $600,000, increased by the 
amount of cumulative taxable income recognized by PRS on the contract 
through the date of the distribution (including amounts recognized as a 
result of the constructive completion), $200,000, decreased by the 
amounts that the partnership has received or reasonably expects to 
receive under the contract, $650,000). Under section 732, X's basis in 
the contract (including the uncompleted property) after the 
distribution is $150,000. Under paragraph (k)(2)(iv)(C) of this 
section, X's basis in the contract is treated as consideration paid by 
X that is allocable to the contract. Under the CCM, X reports no gross 
receipts or costs in Year 2. For Year 3, the completion year, X reports 
its gross contract price of $200,000 (the amount remaining to be paid 
under the terms of the contract less the consideration allocable to the 
contract ($350,000-$150,000)) and its total allocable contract costs of 
$125,000 (the allocable contract costs that X incurred to complete the 
contract ($50,000 + $75,000)), for a profit of $75,000.
    (iv) Section 734(b). The results under section 734(b) are the same 
as in Example 9.
    Example 11.Step-in-the-shoes--PCM--contribution of contract to 
partnership--(i) Facts. In Year 1, X enters into a contract that X 
properly accounts for under the PCM. 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 $600,000 and receives 
$650,000 in progress payments under the contract. Under the 
contract, X performed all of the services required in order to be 
entitled to receive the progress payments, and there was no 
obligation to return the payments or perform any additional services 
in order to retain the payments. In Year 2, X contributes the 
contract (including the uncompleted property) with a basis of $0 and 
$125,000 of cash to partnership PRS in exchange for a one-fourth 
partnership interest. X incurs costs of $10,000, and receives no 
progress payments in Year 2 prior to the contribution of the 
contract. X and the other three partners of PRS share equally in its 
capital, profits, and losses. The parties determine that, at the 
time of the contribution, the fair market value of the contract is 
$160,000. Following the contribution in Year 2, PRS incurs 
additional allocable contract costs of $40,000. PRS 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 (rather than $150,000 as originally estimated by PRS). 
(ii) Tax consequences to X. For Year 1, X reports receipts of 
$750,000 (the completion factor multiplied by the total contract 
price ($600,000/$800,000 x $1,000,000)) and costs of $600,000, for a 
profit of $150,000. Because the mid-contract change in taxpayer 
results from a transaction described in paragraph (k)(3)(i)(I) of 
this section, X is not treated as completing the contract in Year 2. 
Under paragraph (k)(3)(ii)(A) of this section, for Year 2, X reports 
receipts of $12,500 (the completion factor multiplied by the total 
contract price ($610,000/$800,000 xx $1,000,000), $762,500, 
decreased by receipts already reported, $750,000) and costs of 
$10,000, for a profit of $2,500. Under section 722, X's initial 
basis in its interest in PRS is $125,000. Pursuant to paragraph 
(k)(3)(iv)(A)(1) of this section, X must increase its basis in its 
interest in PRS by the amount of gross receipts X recognized under 
the contract, $762,500, and reduce its basis by the amount of gross 
receipts X received under the contract, the $650,000 in progress 
payments. Accordingly, X's basis in its interest in PRS is $237,500.
    (iii) Tax consequences to PRS. Because the mid-contract change 
in taxpayer results from a step-in-the-shoes transaction, PRS must 
account for the contract using the same methods of accounting used 
by X prior to the transaction. The total contract price is the sum 
of any amounts that X and PRS have received or reasonably expect to 
receive under the contract, and total allocable contract costs are 
the allocable contract costs of X and PRS. For Year 2, PRS reports 
receipts of $134,052 (the completion factor multiplied by the total 
contract price

[[Page 46524]]

[($650,000/$725,000) x $1,000,000], $896,552, decreased by receipts 
reported by X, $762,500) and costs of $40,000, for a profit of 
$94,052. For Year 3, PRS 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.
    (iv) Section 704(c). The principles of section 704(c) and Sec.  
1.704-3 apply to allocations of income or loss with respect to the 
contract contributed by X. In this case, the amount of built-in 
income that is subject to section 704(c) is 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) of this section, but before the contribution to the 
partnership. In a constructive completion transaction, the total 
contract price would be $810,000 (the sum of the amounts received 
under the contract and the amount realized in the deemed sale 
($650,000 + $160,000)). X would report receipts of $47,500 (total 
contract price minus receipts already reported ($810,000-$762,500)) 
and costs of $0, for a profit of $47,500. Thus, the amount of built-
in income that is subject to section 704(c) is $47,500. The 
partnership must apply section 704(c) to this income in a manner 
that reasonably accounts for the income over the remaining term of 
the contract. For example, in Year 2, PRS could allocate $26,810 to 
X under section 704(c) (the amount of built-in income, $47,500, 
multiplied by a fraction, the numerator of which is the completion 
factor for the year, $650,000/725,000, less the completion factor 
for the prior year, $610,000/$800,000, and the denominator of which 
is 100 percent reduced by the completion factor for the taxable year 
preceding the event creating the section 704(c) income or loss, 
$610,000/$800,000). The remaining $67,242 would be allocated equally 
among all of the partners. In Year 3, the completion year, PRS could 
allocate $20,690 to X under section 704(c) ($47,500 x [($725,000/
$725,000-$650,000/$725,000)/(100 percent-$610,000/$800,000)]). The 
remaining $7,758 would be allocated equally among all the partners.
    Example 12. Step-in-the-shoes--CCM--contribution of contract to 
partnership--(i) Facts.  The facts are the same as in Example 11, 
except that X and PRS properly account for the contract under the 
CCM, and X has a basis of $610,000 in the contract (including the 
uncompleted property).
    (ii) Tax consequences to X. X reports no income or costs from 
the contract in Years 1 or 2. X is not treated as completing the 
contract in Year 2. Under section 722, X's initial basis in its 
interest in PRS is $735,000 (the sum of $125,000 cash and X's basis 
of $610,000 in the contract (including the uncompleted property)). 
Pursuant to paragraph (k)(3)(iv)(A)(1)(ii) of this section, X must 
reduce its basis in its interest in PRS by the amount of gross 
receipts X received under the contract, or $650,000. Accordingly, 
X's basis in its interest in PRS is $85,000.
    (iii) Tax consequences to PRS. PRS must account for the contract 
using the same methods of accounting used by X prior to the 
transaction. Under the CCM, PRS reports no gross receipts or costs 
in Year 2. For Year 3, the completion year, PRS reports its gross 
contract price of $1,000,000 (the sum of any amounts that X and PRS 
have received or reasonably expect to receive under the contract), 
and total allocable contract costs of $725,000 (the allocable 
contract costs of X and PRS), for a profit of $275,000.
    (iv) Section 704(c). In this case, the amount of built-in income 
that is subject to section 704(c) is 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) of this section, but before the contribution to the 
partnership. In a constructive completion transaction, X would 
report its gross contract price of $810,000 (the sum of the amounts 
received under the contract and the amount realized in the deemed 
sale ($650,000 + $160,000)) and its total allocable contract costs 
of $610,000, for a profit of $200,000. Thus, the amount of built-in 
income that is subject to section 704(c) is $200,000. Out of PRS's 
income of $275,000, in Year 3, $200,000 must be allocated to X under 
section 704(c), and the remaining $75,000 is allocated equally among 
all of the partners.
    Example 13. Step-in-the-shoes--PCM--transfer of a partnership 
interest--(i) Facts.  In Year 1, W, X, Y, and Z each contribute 
$100,000 to form equal partnership PRS. In Year 1, PRS 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, PRS incurs 
costs of $600,000 and receives $650,000 in progress payments under 
the contract. Under the contract, PRS performed all of the services 
required in order to be entitled to receive the progress payments, 
and there was no obligation to return the payment or perform any 
additional services in order to retain the payments. PRS properly 
accounts for the contract under the PCM. In Year 2, W transfers W's 
interest in PRS to T for $150,000. Assume that $10,000 of PRS's Year 
2 costs are incurred prior to the transfer, $40,000 are incurred 
after the transfer; and that PRS receives no progress payments in 
Year 2. Also assume that the fair market value of the contract on 
the date of the transfer is $160,000, that PRS closes its books with 
respect to the contract under section 706 on the date of the 
transfer, and that PRS 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 (rather than $150,000 as 
originally estimated by PRS).
    (ii) Income reporting for period ending on date of transfer. For 
Year 1, PRS reports receipts of $750,000 (the completion factor 
multiplied by total contract price ($600,000/$800,000 x $1,000,000)) 
and costs of $600,000, for a profit of $150,000. This profit is 
allocated equally among W, X, Y, and Z ($37,500 each). Under 
paragraph (k)(3)(ii)(A) of this section, for the part of Year 2 
ending on the date of the transfer of W's interest, PRS reports 
receipts of $12,500 (the completion factor multiplied by the total 
contract price ($610,000/$800,000 x $1,000,000) minus receipts 
already reported ($750,000)) and costs of $10,000 for a profit of 
$2,500. This profit is allocated equally among W, X, Y, and Z ($625 
each).
    (iii) Income reporting for period after transfer. PRS must 
continue to use the PCM. For the part of Year 2 beginning on the day 
after the transfer, PRS reports receipts of $134,052 (the completion 
factor multiplied by the total contract price decreased by receipts 
reported by PRS for the period ending on the date of the transfer 
[($650,000/$725,000 x $1,000,000)-$762,500]) and costs of $40,000, 
for a profit of $94,052. This profit is shared equally among T, X, 
Y, and Z ($23,513 each). For Year 3, PRS 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. The profit for Year 3 is shared equally among T, X, Y, and 
Z ($7,112 each).
    (iv) Tax Consequences to W. W's amount realized is $150,000. W's 
adjusted basis in its interest in PRS is $138,125 ($100,000 
originally contributed, plus $37,500, W's distributive share of 
PRS's Year 1 income, and $625, W's distributive share of PRS's Year 
2 income prior to the transfer). Accordingly, W's income from the 
sale of W's interest in PRS is $11,875. Under paragraph 
(k)(2)(iv)(E) of this section, for purposes of section 751(a), the 
amount of ordinary income attributable to the contract is determined 
as follows. First, the partnership must determine the amount of 
income or loss from the contract that is allocated under section 706 
to the period ending on the date of the sale ($625). Second, the 
partnership must determine the amount of income or loss that the 
partnership would take into account under the constructive 
completion rules of paragraph (k)(2) of this section if the contract 
were disposed of for its fair market value in a constructive 
completion transaction. Because PRS closed its books under section 
706 with respect to the contract on the date of the sale, this 
calculation is treated as occurring immediately after the 
partnership has applied paragraph (k)(3)(ii)(A) of this section on 
the date of the sale. In a constructive completion transaction, the 
total contract price would be $810,000 (the sum of the amounts 
received under the contract and the amount realized in the deemed 
sale ($650,000 + $160,000)). PRS would report receipts of $47,500 
(total contract price minus receipts already reported ($810,000-
$762,500)) and costs of $0, for a profit of $47,500. Thus, the 
amount of ordinary income attributable to the contract is $47,500, 
and W's share of that income is $11,875. Thus, under Sec.  1.751-
1(a), all of W's $11,875 of income from the sale of W's interest in 
PRS is ordinary income.
    (v) Tax Consequences to T. T's adjusted basis for its interest 
in PRS is $150,000. Under Sec.  1.743-1(d)(2), the amount of income 
that would be allocated to T if the contract were disposed of for 
its fair market value (adjusted to account for income from the 
contract for the portion of PRS's taxable year that ends on the date 
of the transfer) is $11,875. Under Sec.  1.743-1(b), the amount of 
T's basis adjustment under section 743(b) is

[[Page 46525]]

$11,875. Under paragraph (k)(3)(v)(B) of this section, the portion 
of T's basis adjustment that is recovered in Year 2 and Year 3 must 
be determined by PRS in a manner that reasonably accounts for the 
adjustment over the remaining term of the contract. For example, PRS 
could recover $6,703 of the adjustment in Year 2 (the amount of the 
basis adjustment, $11,875, multiplied by a fraction, the numerator 
of which is the excess of the completion factor for the year, 
$650,000/$725,000, less the completion factor for the prior year, 
$610,000/$800,000, and the denominator of which is 100 percent 
reduced by the completion factor for the taxable year preceding the 
transfer, $610,000/$800,000). T's distributive share of income in 
Year 2 from the contract would be adjusted from $23,513 to $16,810 
as a result of the basis adjustment. In Year 3, the completion year, 
PRS could recover $5,172 of the adjustment ($11,875 x [($725,000/
$725,000-$650,000/$725,000) / (100 percent-$610,000/$800,000)]). T's 
distributive share of income in Year 3, the completion year, from 
the contract would be adjusted from $7,112 to $1,940 as a result of 
the basis adjustment.

* * * * *
    Par. 4. Section 1.460-6 is amended as follows:
    1. Paragraph (g)(3)(ii)(D) is revised.
    2. Paragraph (g)(4) is revised.
    The revisions read as follows:


Sec.  1.460-6  Look-back method.

* * * * *
    (g) * * *
    (3) * * *
    (ii) * * *
    (D) Information old taxpayer must provide--(1) In general. Except 
as provided in paragraph (g)(3)(ii)(D)(2) of this section, in order to 
help the new taxpayer to apply the look-back method with respect to 
pre-transaction taxable years, any old taxpayer that accounted for 
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 first taxable year ending on or after a step-in-the-shoes 
transaction described in Sec.  1.460-4(k)(3)(i). The required 
information is as follows--
    (i) 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);
    (ii) Any submethods used in the application of PCM (e.g., the 
simplified cost-to-cost method or the 10-percent method);
    (iii) The amount of total contract price reported by year;
    (iv) The numerator and the denominator of the completion factor by 
year;
    (v) 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;
    (vi) Whether the old taxpayer was a corporate or a noncorporate 
taxpayer by year; and
    (vii) Any other information required by the Commissioner by 
administrative pronouncement.
    (2) Special rules for certain pass-through entity transactions. For 
purposes of paragraph (g)(3)(ii)(D)(1) of this section, in the case of 
a transaction described in Sec.  1.460-4(k)(3)(i)(I), the contributing 
partner is treated as the old taxpayer, and the partnership is treated 
as the new taxpayer. In the case of transactions described in 
Sec. Sec.  1.460-4(k)(3)(i)(F), (G), (J), (K), or (L), the old taxpayer 
is not required to provide the information described in paragraph 
(g)(3)(ii)(D)(1) of this section, because information necessary for the 
new taxpayer to apply the look-back method is provided by the pass-
through entity. This paragraph (g)(3)(ii)(D) is applicable for 
transactions on or after August 6, 2003.
* * * * *
    (4) Effective date. Except as provided in paragraph (g)(3)(ii)(D) 
of this section, this paragraph (g) is applicable for transactions on 
or after May 15, 2002.
* * * * *
    Par. 5. In Sec.  1.704-3, a sentence is added at the end of 
paragraph (a)(3)(ii) to read as follows:


Sec.  1.704-3  Contributed property.

    (a) * * *
    (3) * * *
    (ii) * * * See Sec.  1.460-4(k)(3)(v)(A) for a rule relating to the 
amount of built-in income or built-in loss attributable to a contract 
accounted for under a long-term contract method of accounting.
* * * * *
    Par. 6. Section 1.722-1 is amended by adding a new sentence between 
the sixth and seventh sentences to read as follows:


Sec.  1.722-1  Basis of contributing partner's interest.

     * * * See Sec.  1.460-4(k)(3)(iv)(A) for rules relating to basis 
adjustments required where a contract accounted for under a long-term 
contract method of accounting is transferred in a contribution to which 
section 721(a) applies.
* * * * *
    Par. 7. A sentence is added at the end of Sec.  1.723-1 to read as 
follows:


Sec.  1.723-1  Basis of property contributed to partnership.

     * * * See Sec.  1.460-4(k)(3)(iv)(B)(2) for rules relating to 
adjustments to the basis of contracts accounted for using a long-term 
contract method of accounting that are acquired in certain 
contributions to which section 721(a) applies.
    Par. 8. In Sec.  1.732-1, a sentence is added at the end of 
paragraph (c)(1)(i) to read as follows:


Sec.  1.732-1  Basis of distributed property other than money.

* * * * *
    (c) * * *
    (1) * * *
    (i) * * * See Sec.  1.460-4(k)(2)(iv)(D) for a rule determining the 
partnership's basis in a long-term contract accounted for under a long-
term contract method of accounting.
* * * * *
    Par. 9. In Sec.  1.734-1, the undesignated paragraph immediately 
following paragraph (b)(1)(ii) is revised to read as follows:


Sec.  1.734-1  Optional adjustment to basis of undistributed 
partnership property.

* * * * *
    (b) * * *
    (i) * * *
    (ii) * * *
    See Sec.  1.460-4(k)(2)(iv)(D) for a rule determining the 
partnership's basis in a long-term contract accounted for under a long-
term contract method of accounting. The provisions of this paragraph 
(b)(1) are illustrated by the following examples:
* * * * *
    Par. 10. Section 1.743-1 is amended as follows:
    1. A sentence is added at the end of paragraph (d)(2).
    2. A sentence is added at the end of paragraph (j)(2).
    The additions read as follows:


Sec.  1.743-1  Optional adjustment to basis of partnership property.

* * * * *
    (d) * * *
    (2) * * * See Sec.  1.460-4(k)(3)(v)(B) for a rule relating to the 
computation of income or loss that would be allocated to the transferee 
from a contract accounted for under a long-term contract method of 
accounting as a result of the hypothetical transaction.
* * * * *
    (j) * * *
    (2) * * * See Sec.  1.460-4(k)(3)(v)(B) for rules relating to the 
effect of a basis adjustment under section 743(b) that is allocated to 
a contract accounted for under a long-term contract method of 
accounting in determining the

[[Page 46526]]

transferee's distributive share of income or loss from the contract.
* * * * *
    Par. 11. In Sec.  1.751-1, a sentence is added at the end of 
paragraph (a)(2) to read as follows:


Sec.  1.751-1  Unrealized receivables and inventory items.

    (a) * * *
    (2) * * * See Sec.  1.460-4(k)(2)(iv)(E) for rules relating to the 
amount of ordinary income or loss attributable to a contract accounted 
for under a long-term contract method of accounting.
* * * * *
    Par. 12. Section 1.755-1 is amended as follows.
    1. Adding a sentence at the end of paragraph (b)(1)(ii).
    2. Paragraph (c)(5) is redesignated as paragraph (c)(6).
    3. New paragraph (c)(5) is added.
    The additions read as follows:


Sec.  1.755-1  Rules for allocation of basis.

* * * * *
    (b) * * *
    (1) * * *
    (ii) * * * See Sec.  1.460-4(k)(3)(v)(B) for a rule relating to the 
computation of income or loss that would be allocated to the transferee 
from a contract accounted for under a long-term contract method of 
accounting as a result of the hypothetical transaction.
* * * * *
    (c) * * *
    (5) Cross reference. See Sec.  1.460-4(k)(3)(v)(B) for a rule 
relating to the computation of unrealized appreciation or depreciation 
in a contract accounted for under a long-term contract method of 
accounting.
* * * * *

Dale F. Hart,
Acting Deputy Commissioner for Services and Enforcement.
[FR Doc. 03-18484 Filed 8-5-03; 8:45 am]
BILLING CODE 4830-01-P