[Federal Register: July 16, 2004 (Volume 69, Number 136)]
[Rules and Regulations]               
[Page 42551-42559]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr16jy04-2]                         

=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9137]
RIN 1545-BA81

 
Partnership Transactions Involving Long-Term Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains final 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: Effective Date: These regulations are effective July 16, 2004.
    Applicability Date: These regulations apply to transactions on or 
after May 15, 2002.

FOR FURTHER INFORMATION CONTACT: Richard Probst at (202) 622-3060 (not 
a toll-free number).

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

[[Page 42552]]

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), the Treasury 
Department and 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. On 
August 6, 2003, a notice of proposed rulemaking (REG-128203-02) 
relating to partnership transactions involving contracts accounted for 
under a long-term contract method of accounting was published in the 
Federal Register (68 FR 46516). Comments were received from the public 
in response to the notice of proposed rulemaking. No public hearing was 
requested or held. After consideration of all comments, the proposed 
regulations are adopted as amended by this Treasury decision.

Explanation and Summary of Contents

    The regulations proposed on August 6, 2003 provide that the 
constructive completion rules 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 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). One commentator suggested clarifying that the 
constructive completion rules apply to other distributions of an 
interest in a partnership (lower-tier partnership) holding one or more 
contracts accounted for under a long-term contract method of accounting 
by another partnership (upper-tier partnership). This comment has been 
adopted.
    One commentator suggested that the final regulations clarify the 
application of the constructive completion rules if a partnership that 
holds a contract accounted for under a long-term contract method of 
accounting terminates under section 708(b)(1)(A) because the number of 
its owners is reduced to one. In response to this comment, the final 
regulations provide that the entire contract will be treated as being 
distributed from the partnership for purposes of the constructive 
completion rules, because the partnership ceases to exist for tax 
purposes. In addition, the final regulations provide that the 
partnership must apply the constructive completion rules immediately 
prior to the transaction or transactions resulting in the termination 
of the partnership.
    Consistent with Sec.  1.706-1(c)(2)(ii), the proposed 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. The proposed regulations provide that 
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. The proposed regulations also provide 
similar rules 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.
    The proposed regulations requested comments 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. Under section 1377(a)(1) and Sec.  
1.1377-1(a), 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. Under section 1377(a)(2) and Sec.  1.1377-1(b), 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. 
No comments were received.
    The Treasury Department and IRS have concluded that similar rules 
should be provided for transfers of S corporation stock and conversions 
to and from S corporation status. Thus, the final regulations generally 
provide that upon the transfer of stock in an S corporation holding a 
contract accounted for under a long-term contract method of accounting, 
or the conversion to or from S corporation status by a corporation 
holding such a contract, the step-in-the-shoes rules apply to the 
contract only if the S corporation's books are closed under section 
1362(e)(3), section 1362(e)(6)(C), section 1362(e)(6)(D), section 
1377(a)(2), or Sec.  1.1502-76. If the S corporation's books are not 
closed, the S corporation computes its income or loss from the contract 
for the period that includes the date of the transfer as though no 
change in taxpayer had occurred with respect to the contract, and must 
pro rate income from the contract in accordance with the rules 
generally applicable to such transfers or conversions.
    In Rev. Rul. 73-301 (1973-2 C.B. 215), 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). The proposed 
regulations requested 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. 
No written comments were received. However, if a contract accounted for 
under a long-term contract method of accounting is contributed to a 
partnership, then, to the extent that progress payments give rise to a 
liability, section 752(b) would require the transferring partner to 
reduce its basis in its partnership by the

[[Page 42553]]

amount of that liability, either when the contract is contributed (to 
the extent that the liability is allocated to other partners) or when 
the liability is extinguished. Thus, because the proposed regulations 
require the partner to reduce the partner's basis in its partnership 
interest by the amount of progress payments received, the proposed 
regulations could require two reductions in basis for the same 
payments.
    Ordinarily, progress payments do not give rise to liabilities 
within the meaning of section 752 and the regulations thereunder. 
However, to the extent that there is a case in which a progress payment 
gives rise to such a liability, the Treasury Department and IRS agree 
that taxpayers should not be required to reduce their basis twice for 
the same progress payment, and believe that a similar rule should be 
provided for transfers to corporations. Accordingly, upon a 
contribution of a contract accounted for under a long-term contract 
method of accounting to a partnership or corporation, the final 
regulations provide that the required reduction in basis for progress 
payments received does not apply to the extent that such progress 
payments give rise to a liability (other than a liability described in 
section 357(c)(3)).
    Finally, one commentator suggested that the regulations clarify 
that the fair market value of a contract contributed to a partnership 
does not necessarily equal the full amount of expected remaining profit 
on the contributed contract. The Treasury Department and IRS believe 
that it is sufficiently clear under the proposed regulations that the 
fair market value of the contributed contract is determined under 
general tax principles. Thus, this comment has not been adopted.

Special Analyses

    It has been determined that this Treasury Decision 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, these 
regulations were submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
businesses.

Drafting Information

    The principal authors of these 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 the Treasury Department and IRS participated in their 
development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read, in 
part, as follows:

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


0
Par. 2. Section 1.460-0 is amended as follows:
0
1. Revising the entry for paragraph 1.460-4(k)(2)(iv).
0
2. Adding entries for Sec.  1.460-4(k)(2)(iv)(A) through (E).
0
3. Revising the entry for Sec.  1.460-4(k)(3)(iv).
0
4. Revising the entry for Sec.  1.460-4(k)(3)(iv)(A)(2) and adding 
entries for Sec.  1.460-4(k)(3)(iv)(C) and (D).
0
5. Revising the entry for Sec.  1.460-4(k)(3)(v).
0
6. Adding entries for Sec.  1.460-4(k)(3)(v)(A) through (D).
0
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.
(D) Exceptions to step-in-the-shoes rules for S corporations.
(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.
* * * * *

0
Par. 3. Section 1.460-4 is amended as follows:
0
1. Revising the sixth sentence in paragraph (k)(1).
0
2. Revising paragraph (k)(2)(iv).
0
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''.
0
4. Revising paragraph (k)(3)(i)(I).
0
5. Redesignating paragraphs (k)(3)(i)(J), (K) and (L) as paragraphs 
(k)(3)(i)(K), (L) and (M), respectively.
0
6. Adding a new paragraph (k)(3)(i)(J).
0
7. Revising newly designated paragraph (k)(3)(i)(K).
0
8. Revising paragraph (k)(3)(iv).
0
9. Revising paragraph (k)(3)(v).
0
10. Adding paragraph (k)(5) Example 9 through Example 13.
0
11. Revising the first sentence in paragraph (k)(6).
    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 both to the distribution of a 
contract accounted for under a long-term contract method of accounting 
by a

[[Page 42554]]

partnership to a partner and to the distribution of an interest in a 
partnership (lower-tier partnership) holding (either directly or 
through other partnerships) one or more contracts accounted for under a 
long-term contract method of accounting by another partnership (upper-
tier partnership). Notwithstanding the previous sentence, 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 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). If a partnership 
that holds a contract accounted for under a long-term contract method 
of accounting terminates under section 708(b)(1)(A) because the number 
of its owners is reduced to one, the entire contract will be treated as 
being distributed from the partnership for purposes of the constructive 
completion rules, and the partnership must apply paragraph (k)(2) of 
this section immediately prior to the transaction or transactions 
resulting in the termination of the partnership.
    (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;
    (K) Transfers of partnership interests (other than transfers which 
cause the partnership to terminate under section 708(b)(1)(A));
* * * * *
    (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 (except to the extent such gross receipts give rise to a 
liability other than a liability described in section 357(c)(3)).
    (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.  
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

[[Page 42555]]

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 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.
    (D) Exceptions to step-in-the-shoes rules for S corporations. Upon 
a transfer described in paragraph (k)(3)(i)(F) of this section or a 
conversion described in paragraph (k)(3)(i)(G) 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 S corporation's books are closed under section 1362(e)(3), section 
1362(e)(6)(C), section 1362(e)(6)(D), section 1377(a)(2), or Sec.  
1.1502-76 on the date of the transfer or conversion. In these cases, 
the corporation 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 transfers, the corporation 
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 in accordance with the rules 
generally applicable to transfers of S corporation stock and 
conversions to or from S corporation status. This paragraph 
(k)(3)(iv)(D) is applicable for transactions on or after July 16, 2004. 
In addition, this paragraph (k)(3)(iv)(D) may be relied upon for 
transactions on or after May 15, 2002.
    (v) Special rules relating to certain partnership transactions--(A) 
Section 704(c)--(1) Contributions of contracts. The principles of 
section 704(c)(1)(A), section 737, and the regulations thereunder 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)(1)(A) 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, at the time of 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

[[Page 42556]]

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 
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, there is no basis adjustment under section 734(b).
    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

[[Page 42557]]

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, or $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) - $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 x $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

[[Page 42558]]

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 $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.
* * * * *
    (6) Effective date. Except as provided in paragraph (k)(3)(iv)(D) 
of this section, this paragraph (k) is applicable for transactions on 
or after May 15, 2002. * * *

0
Par. 4. Section 1.460-6 is amended by revising paragraphs (g)(3)(ii)(D) 
and (g)(4) to 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.  
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.
* * * * *

0
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.
* * * * *

0
Par. 6. Section 1.722-1 is amended by adding a 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.
* * * * *
0
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.

0
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.

* * * * *

[[Page 42559]]

    (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.
* * * * *

0
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) * * *
    (1) * * *
    (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:
* * * * *

0
Par. 10. Section 1.743-1 is amended as follows:
0
1. A sentence is added at the end of paragraph (d)(2).
0
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 transferee's distributive share of income 
or loss from the contract.
* * * * *

0
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.
* * * * *

0
Par. 12. Section 1.755-1 is amended as follows.
0
1. Adding a sentence at the end of paragraph (b)(1)(ii).
0
2. Paragraph (c)(5) is redesignated as paragraph (c)(6).
0
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.
* * * * *

0
Par. 13. Section 1.1362-3 is amended by adding a sentence at the end of 
paragraph (a) to read as follows:


Sec.  1.1362-3  Treatment of S termination year.

    (a) * * * See Sec.  1.460-4(k)(3)(iv)(D) for rules relating to the 
computation of the S corporation's income or loss from a contract 
accounted for under a long-term contract method of accounting in the S 
termination year.
* * * * *

0
Par. 14. Section 1.1377-1 is amended by adding a sentence is at the end 
of paragraph (a)(1) to read as follows:


Sec.  1.1377-1  Pro rata share.

    (a) * * *
    (1) * * * See Sec.  1.460-4(k)(3)(iv)(D) for rules relating to the 
computation of the shareholders' pro rata share of S corporation's 
income or loss from a contract accounted for under a long-term contract 
method of accounting.
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: July 1, 2004.
Gregory Jenner,
Acting Assistant Secretary of the Treasury.
[FR Doc. 04-15833 Filed 7-15-04; 8:45 am]
BILLING CODE 4830-01-P