9055 / What types of contracts are considered "long-term contracts" for purposes of determining the proper method of accounting?
Editor’s Note: The 2017 tax reform legislation expands the exception for small long-term construction contracts from the requirement to use the percentage-of-completion method. See heading in Q 9057.
A long-term contract is any contract that provides for the manufacture, building, installation, or construction of property that will not be completed within the taxable year that the contract was executed.1
Despite this general definition, a manufacturing contract is only treated as a long-term contract if it provides for the manufacture of:2
(1) Unique items which are not normally carried as finished goods inventory; or
(2) Items which would normally require more than a 12 month production period to complete (regardless of the duration of the actual contract).3
An item is considered “unique” if it was designed to meet the needs of a specific customer and is generally not suitable for the use of other customers without significant modification.4 A taxpayer can use the IRS’ safe harbor to show that a product is not unique in the following circumstances:
(1) Short production period. If an item could normally be manufactured within ninety days or less, then it is not considered to be a unique item. If multiple orders are involved, this test is satisfied if each unit can be manufactured within ninety days;5
(2) Customized item. An item is not considered unique if 10 percent or less of the total contract cost is attributed to the cost of customizing the item;6
(3) Inventoried item. An item that might otherwise be considered unique ceases to be unique when the taxpayer begins to normally include similar items in its finished goods inventory.7
The item’s production period begins when the taxpayer has incurred at least 5 percent of the total contract cost and ends when the item is ready for sale and all reasonably expected production activities have been completed.8
Construction contracts, for this purpose, include the improvement or building of real property, reconstruction or rehabilitation of real property, contracts for the installation of an integral component to real property, and contracts for the improvement of real property.9
See Q 9056 for the rules governing accounting for long-term contracts.
1. IRC § 460(f)(1); Treas. Reg. § 1.460-1(b)(1).
2. IRC § 460(f)(2); Treas. Reg. § 1.460-2(a).
3. IRC § 460(f)(2)(B); Treas. Reg. § 1.460-2(a)(2).
4. Treas. Reg. § 1.460-2(b)(1); Sierracin Corp. v. Comm., 90 TC 341 (1988).
5. Treas. Reg. § 1.460-2(b)(2)(i).
6. Treas. Reg. § 1.460-2(b)(2)(ii).
7. Treas. Reg. § 1.460-2(b)(2)(iii).
8. Treas. Reg. § 1.460-2(c)(1).
9. Treas. Reg. § 1.460-3(a).