Defining long-term contracts.

Two recently released field service advice (FSA) memoranda provide insight into definitional issues for long-term contracts. Although written in 1993, both FSAs predict the approach used in the Sec. 460 proposed regulations issued earlier this year.

FSA 1999-1122 involved a taxpayer that argued it fell under the unique-item exception for manufacturing contracts. The taxpayer made automotive molds and dies to clients' specifications. It relied on the two-prong approach taken in Sierracin Corp., 90TC 341 (1988), the only case that addresses the definition of a unique item. According to Sierracin, two main factors classify a long-term contract: (1) whether an item is custom designed and (2) whether contracts are subject to unpredictable risks that make it difficult for a taxpayer to account for ultimate profit and loss on an interim basis. FSA 1999-1122 specifically rejected reliance on the unpredictability of risks and instead focused solely on whether the item was custom designed. It stated that risk is not a criterion in determining uniqueness, especially if the completed-contract method is not involved.

Prop. Regs. Sec. 1.460-2 also rejects the two-prong Sierracin approach. It focuses on whether an item was specifically designed for a customer. A single-factor approach may cause many manufacturing clients to fall under Sec. 460. Prop. Regs. Sec. 1.4602(b)(2) provides three safe harbors for using the unique-item exception: (1) completing an item within 90 days, (2) customizing an item from an existing design in which customizing activities do not exceed 5% of total costs and (3) carrying similar items in finished goods inventory.

FSA 1999-1108 involved a taxpayer with computer hardware and software installation contracts. The taxpayer contended that its contracts were long-term contracts qualifying for the completed-contract method available under Regs. Sec. 1.451-3. To be long-term, contracts had to be building, installation, construction or manufacturing contracts. The IRS determined that the taxpayer did not have manufacturing contracts, although it conceded that the definition of manufacturing was far from certain. The Service also cited several rulings involving service providers.

With regard to building, installation or construction contracts, the proposed regulations take a similar approach. Prop. Regs. Sec. 1.460-3(a) states that these contracts only involve real property. This distinction will help nonmanufacturing taxpayers concerned about falling under Sec. 460. Prior IRS guidance had seemed to indicate that service providers should not be subject to long-term contract accounting, although there was no definitive authority on this issue.

FROM HELEN S. YANCHISIN, J.D., WASHINGTON, DC