IRS issues ruling on long-term contracts

Tax Hot Topics newsletter The IRS ruled in PLR 202046001 that a taxpayer’s production and installation contract is subject to the percentage-of-completion method (PCM) under Section 460(f)(2), and that the taxpayer’s prepayments to its subsidiary are contract costs incurred in the contracting year for purposes of computing the completion factor under the PCM.

The taxpayer in the ruling is a business that entered into a contract to design, manufacture, construct and install certain products. Under the contract, it was responsible for procuring or manufacturing the necessary raw materials, parts and components. It reasonably expected the average production period would exceed 12 months and made prepayments in the contracting year to its subsidiary for those items.

Generally, Section 460(a) requires a taxpayer to use the PCM for its long-term contracts, which under Section 460(f)(2) includes a long-term contract that involves the manufacture of any unique item of a type which is not normally included in finished goods inventory or any item that normally requires more than 12 months to complete.

The IRS ruled that the contract is a long-term manufacturing contract subject to the PCM because the taxpayer’s average production period for all the products manufactured under the contract takes more than 12 months to complete. In addition, the taxpayer’s prepayments to its subsidiary in the contracting year are subject to the PCM because such costs are direct material costs, since they are incurred to procure parts and raw materials related to the long-term contract. The IRS held that the taxpayer must treat the prepayments to its subsidiary as incurred in the contracting year because under Treas. Reg. Sec. 1.461-4(d)(2)(ii), the contract costs are incurred either when the subsidiary provides the raw materials, parts and components to the taxpayer or when the taxpayer makes payments to the subsidiary for the raw materials, parts and components, whichever is earlier.

Sharon Kay
Washington National Tax Office
T +1 202 861 4140

Caleb Cordonnier
Washington National Tax Office
T +1 202 521 1555

Jason Seo
Senior Associate
Washington National Tax Office
T +1 202 521 1556

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