Construction Industry - Audit Technique Guide - Uncle Fed's Tax ...

Treas. Reg. § 1.460-1(e)(3). Exceptions- - (i) Severance for PCM. A taxpayer may notsever under this paragraph (e) a long-term contract that would be subject to the PCMwithout obtaining the Commissioner's prior written consent.In the case of options and change orders, subject to the above Treasury Regulation,a taxpayer must sever an agreement that increases the number of units to be suppliedto the customer, such as through the exercise of an option or the acceptance of achange order, if the agreement provides for separate delivery or separate acceptance ofthe additional units.Example of Severance:On January 1, 2001, a construction contractor enters into an agreement to build twooffice buildings in different areas of a large city. The agreement provides that the twooffice buildings will be completed and accepted by the customer in 2002 and 2003,respectively, and that the contractor will be paid $1 million and $1.5 million for the twooffice buildings, respectively. The agreement will provide a reasonable profit from theconstruction of each building. Unless the contractor is required to use the PCM toaccount for the contract, the contractor is required to sever this contract because thebuildings are independently priced, the agreement provides for separate delivery andacceptance of the buildings, and, as each building will generate a reasonable profit, areasonable business person would have entered into separate agreements for theterms agreed upon for each building.Example of Aggregation:In 2001, a contractor enters into two separate contracts, as the result of a singlenegotiation, to construct two identical special use buildings (i.e. nuclear plant). Becausethe contractor has never constructed this type of building before, the contractoranticipates that it will incur substantially higher costs to construct the first building. If theagreements are treated as separate contracts, the first contract probably will produce asubstantial loss, while the second contract probably will produce substantial profit.Based upon these facts, aggregation is required because the buildings areinterdependently priced and a reasonable business person would not have entered thefirst agreement without also entering into the second.Example of Contract Options:A contractor enters into a contract with a developer to construct 10 homes on landowned by the developer to be built in year 1. The contract provides an option in whichthe contractor is to build an additional 10 homes. In year 2, the option is exercised andthe additional homes are built. The option would be severed from the original contract.2-11