contract price in gross income as the taxpayer incurs allocable contract costs.
(2) Computations. To determine the income from a long-term contract, a taxpayer - -
(i) Computes the completion factor for the contract, which is the ratio of the cumulative allocable contract costs that the taxpayer has incurred through the end of the taxable year, to the estimated total allocable contract costs that the taxpayer reasonably expects to incur under the contract;
(ii) Computes the amount of cumulative gross receipts from the contract by multiplying the completion factor by the total contract price;
(iii) Computes the amount of current-year gross receipts, which is the difference between the amount of cumulative gross receipts for the current taxable year and the amount of cumulative gross receipts for the immediately preceding taxable year (the difference can be a positive or negative number); and
(iv) Takes both the current-year gross receipts and the allocable contract costs incurred during the current year into account in computing taxable income.
Example of Cost-to-Cost PCM:
B enters into a construction contract in 2001 for which B is to receive $10 million. B estimates that its total costs under the contract will be $8 million. At the end of 2002, B has incurred $4 million of its estimated costs on this project. If using this formula, B included $3 million of the contract price as gross receipts in 2001, B must include $2 million as gross receipts for 2002:
($4,000,000 ÷ $8,000,000) x ($10,000,000) – ($3,000,000) = $2,000,000
Allocable Contract Costs
The allocable contract costs that are used in determining the cost-to-cost method are provided in Treas. Reg. § 1.460-5(b) which has a direct link to IRC § 263A costs.
Treas. Reg. § 1.460-5(b) Cost allocation method for contracts subject to PCM--(1) In general. Except as otherwise provided in paragraph (b)(2) of this section, a taxpayer must allocate costs to each long-term contract subject to the PCM in the same manner that direct and indirect costs are capitalized to property produced by a taxpayer under § 1.263A-1(e) through (h). Thus, a taxpayer must allocate to each long-term contract subject to the PCM all direct costs and certain indirect costs properly allocable to the long-term contract (i.e., all costs that directly benefit or are incurred by reason of the
performance of the long-term contract). However, see paragraph (c) of this section concerning an election to allocate contract costs using the simplified cost-to-cost method. As in section 263A, the use of the practical capacity concept is not permitted. See § 1.263A-2(a)(4).
Direct costs listed in Treas. Reg. § 1.263A-1(e)(2) include: • Direct material costs
• Direct labor costs
Indirect costs under Treas. Reg. § 1.263A-1(e)(3) include: • Indirect labor costs
• Officers’ compensation
• Pension and other related costs • Employee benefit expenses • Indirect material costs
• Purchasing costs • Handling costs • Storage costs • Cost recovery • Depletion • Rent • Taxes • Insurance • Utilities
• Repairs and maintenance • Engineering and design costs • Spoilage
• Tools and equipment • Quality control
• Bidding costs
• Licensing and franchise costs • Interest
• Capitalizable service costs
Subject to PCM, direct material and labor costs, are properly allocable to the long-term contract are all costs that directly benefit or are incurred through the contract’s
performance. Treas. Reg. § 1.460-5(b)(1). Similarly, indirect costs are properly allocable to property produced or property acquired for resale when the costs directly benefit or are incurred by reason of the performance of production or resale activities. Treas. Reg. § 1.263A-1(e)(3)(i). Some indirect costs, on the other hand, may benefit both the long-term contract and other business activities of the taxpayer and are not always specifically identified to a particular long-term contract. This allocation may be a
specific “facts-and-circumstances” method, including the specific identification (or tracing) method, burden rate method (i.e., ratios based on direct costs, direct labor, etc.), standard cost method, a “simplified method” provided in Treas. Reg. §§ 1.263A- 2(b) and 1.263A-3(d), or any other reasonable method (as defined under Treas. Reg. § 1.263A-1(f)(4)). See Treas. Reg. § 1.263A-1(f) and (g)(3).
Direct Material Costs
Direct material costs include the costs of those materials that become an integral part of specific property produced and those materials that are consumed in the ordinary
course of production that can be identified or associated with particular units or groups of units of property produced. Treas. Reg. § 1.263A-1(e)(2)(i)(A). Direct material costs must be allocated to a long-term contract when “dedicated” to the contract. Thus, a taxpayer dedicates direct materials by associating them with a specific contract, including by purchase order, entry on books and records, or shipping instructions. Treas. Reg. § 1.460-5(b)(2)(i). Therefore, uninstalled materials that are dedicated to a contract become an allocable job cost.
Direct Labor Costs
Direct labor costs include the costs of labor that can be identified or associated with the long-term contract. For this purpose, labor encompasses full-time and part-time
employees, as well as contract employees and independent contractors. Direct labor costs include all elements of compensation other than employee benefit costs described in Treas. Reg. § 1.263A-1(e)(3)(ii)(D). Elements of direct labor costs include basic compensation, overtime pay, vacation pay, holiday pay, sick leave pay (other than payments pursuant to a wage continuation plan under section 105(d) as it existed prior to its repeal in 1983), shift differential, payroll taxes, and payments to a supplemental unemployment benefit plan. See Treas. Reg. § 1.263A-1(e)(2)(i)(B).
Bidding Costs
Bidding expenses are those costs incurred by a contractor in the solicitation of a long- term contract. The taxpayer must defer all bidding costs paid or incurred in the solicitation of a particular contract until the contract is awarded. If the contract is
awarded to the taxpayer, the bidding costs become part of the indirect costs allocated to the subject matter of the contract. If the contract is not awarded to the taxpayer, bidding costs are deductible in the taxable year that the contract is awarded to another party, or in the taxable year that the taxpayer is notified in writing that no contract will be awarded and that the contract (or a similar or related contract) will not be rebid, or in the taxable year that the taxpayer abandons its bid or proposal, whichever occurs first. See Treas. Reg. § 1.263A-1(e)(3)(ii)(T).
Subject to the exception in IRC § 460(c)(2)(costs identified under cost-plus and certain federal contracts) , costs not allocable to the contract are independent research and development expenses, expenses for unsuccessful bids and proposals, and marketing, selling, and advertising expenses. See IRC § 460(c)(4). Treas. Reg. § 1.263A-
1(e)(3)(iii) provides a list of additional indirect costs not allocable to the long-term contract under Treas. Reg. § 1.460-5(b). These indirect costs include “deductible service costs,” which generally include costs incurred by reason of the taxpayer’s overall management or policy guidance functions, such costs from the board of
directors, chief executive, financial, accounting, and legal officers. See Treas. Reg. § 1.263A-1(e)(3)(iii)(K) and (e)(4)(ii)(B) and (e)(4)(iv)(A). Even though a service cost is classified as “general and administrative,” however, it is allocable to the long-term contract if it directly benefits or is incurred by reason of the taxpayer’s performance of the production or resale activities. Examples are costs from data processing, personnel operations, security services, and legal services. See Treas. Reg. § 1.263A-
1(e)(4)(i)(A) and (B) and (e)(4)(ii) -(iii). Nondeductible Costs
Costs that would normally be allocable to a contract but are nondeductible by the Internal Revenue Code are not an allocable contract cost. A common example would be the nondeductible portion of meals per IRC § 274. The amount incurred as well as the total estimated amount of the nondeductible cost must be removed from the percentage of completion computation.
Treas. Reg. § 1.460-5(f) Special rules applicable to costs allocated under this section-- (1) Nondeductible costs. A taxpayer may not allocate any otherwise allocable contract cost to a long-term contract if any section of the Internal Revenue Code disallows a deduction for that type of payment or expenditure (e.g., an illegal bribe described in section 162(c)).