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Notice of Proposed Rulemaking: Partnership Transactions Involving Long-Term Contracts
7.2 Explanation and Summary of Contents
Written and electronic comments and requests for a public hearing must be received by November 4, 2003.
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. 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 www.irs.gov/regs.
Concerning the regulations, Richard Probst, (202) 622-3060; concerning submissions, Guy Traynor, (202) 622-7180 (not toll-free numbers).
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 (T.D. 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.
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 (T.D. 8995; 2002-1 C.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, 2002-1 C.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 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 §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 §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 §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 §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 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 §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 §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 §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.
6. 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 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.
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.
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 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.
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 §1.460-4(k) (2)(iv)(A) through (E).
3. Revising the entry for §1.460-4(k) (3)(iv).
4. Revising the entry for §1.460-4(k) (3)(iv)(A)(2) and adding an entry for § 1.460-4(k)(3)(iv)(C).
5. Revising the entry for §1.460-4(k) (3)(v).
6. Adding entries for §1.460-4(k) (3)(v)(A) through (D).
7. Adding entries for §1.460-6(g) (3)(ii)(D)(1) and (2).
§1.460-0 Outline of regulations under section 460. * * * * *
§1.460-4 Methods of accounting for long-term contracts. * * * * *
§1.460-6 Look-back method. * * * * *
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), 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.
(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. * * *
(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 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 §1.708-1(b)(4) (relating to terminations under section 708(b)(1)(B)) or §1.708-1(c)(3)(i) (relating to certain partnership mergers).
(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.
(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 —
(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 §§1.1502-19 and 1.1502-32(a)(3)(ii).
(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 to the basis adjustment rule of paragraph (k)(3)(iv)(A) of this section).
(v) Special rules relating to certain partnership transactions — (A) Section 704(c) — (1) Contributions of contracts. The principles of section 704(c) and §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 sections 704(c) and 1.704-3 apply to allocations of income or loss with respect to a long-term contract that is revalued by a partnership under §1.704-1(b)(2)(iv)(f). 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.
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 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.
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 x $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 [($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 §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).
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 §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 §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 §1.743-1(b), the amount of T's basis adjustment under section 743(b) is $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.
(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 §1.460-4(k)(3)(i). The required information is as follows -
(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 §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 §§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.
Par. 5. In §1.704-3, a sentence is added at the end of paragraph (a)(3)(ii) to read as follows:
§1.704-3 Contributed property. (a) * * *
(ii) * * * See §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:
§1.722-1 Basis of contributing partner's interest. * * *See §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 §1.723-1 to read as follows:
§1.723-1 Basis of property contributed to partnership. * * * See §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 §1.732-1, a sentence is added at the end of paragraph (c)(1)(i) to read as follows:
§1.732-1 Basis of distributed property other than money. * * * * *
(i) * * * See §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 §1.734-1, the undesignated paragraph immediately following paragraph (b)(1)(ii) is revised to read as follows:
§1.734-1 Optional adjustment to basis of undistributed partnership property. * * * * *
See §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).
§1.743-1 Optional adjustment to basis of partnership property. * * * * *
(2) * * * See §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.
(2) * * * See §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 transferee's distributive share of income or loss from the contract.
Par. 11. In §1.751-1, a sentence is added at the end of paragraph (a)(2) to read as follows:
§1.751-1 Unrealized receivables and inventory items. (a) * * *
(2) * * * See §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.
§1.755-1 Rules for allocation of basis. * * * * *
(ii) * * * See §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. * * *
(5) Cross reference. See §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.
Note (Filed by the Office of the Federal Register on August 5, 2003, 8:45 a.m., and published in the issue of the Federal Register for August 6, 2003, 68 F.R. 46516)
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.
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