New Directives from the LMSB

By Cory Tull, J.D., Washington, DC

Editor: David J. Kautter, CPA

The IRS Large and Mid-Size Business (LMSB) Division has issued several new directives related to issues targeted under its issue-tiering strategy. The directives, each dated September 15, 2009, relate to the Tier I mixed service costs issue and two Tier II issues: contractual allowances in the health care industry and the super completed contract method of accounting.

Contractual Allowance Issue

LMSB-4-0909-036 moves the Tier II issue on contractual allowances in the health care industry from active to monitoring status. According to the directive, the IRS will continue to monitor the issue using guidance under Technical Advice Memorandum (TAM) 200619020, released on May 12, 2006, and the first contractual allowance Industry Director Directive (IDD) LMSB-04-0807-056, issued on September 10, 2007.

Super Completed Contract Method

LMSB-04-0209-006 updates and supersedes a previous IDD (LMSB-04- 0207-012) that the IRS issued on March 13, 2007. The current IDD is intended to provide guidance pending the issuance of final regulations under Sec. 460 expanding the home construction contract exemption and amending rules for taxpayerinitiated changes in accounting method.

In the IDD, the IRS describes taxpayers’ misuse of the completed contract method (CCM) of accounting as “a growing trend within the residential construction industry.” The IRS provides five scenarios to illustrate the following two key misuses:

  • Taxpayers improperly treat residential land sales contracts and long-term construction contracts (including contracts for subcontract work for common improvements) as home construction contracts eligible for the CCM.
  • Taxpayers postpone recognition that a contract is considered complete to improperly defer income (and expenses) under the CCM.

The IDD directs that the improper use of the CCM should be raised as an audit issue in cases involving residential land developers, homebuilders, and/or their subcontractors. The IDD also directs revenue agents to limit examinations of the issue to contract deferrals that extend beyond two tax years after taxpayers entered into the contracts. However, the IRS notes that this guidance does not allow taxpayers a deferral of income for two years. Instead, it merely provides direction to examiners as to which contracts to examine.

Finally, the IDD provides audit techniques that examiners should follow in investigating the issue, as well as several pro forma information document requests (IDRs) and Forms 5701, Notice of Proposed Adjustment.

Mixed Service Costs Issue

LMSB-04-0809-033 provides field guidance on the allocation of resources to examinations of mixed service costs (MSC) subject to the reasonableness requirement of Regs. Sec. 1.263A-1(e)(3)(i). This is a Tier I issue.

The IDD, the fifth that the LMSB has issued on MSC issues, focuses mostly on electric utilities required to switch from the simplified service cost method of accounting for MSC to a facts-and-circumstances method. The IDD classifies certain mixed service cost allocation methods according to their relative significance to the LMSB compliance priorities. Specifically, it instructs examiners not to challenge the following methods of allocating mixed service costs that are considered relatively less significant for compliance, subject to the approval of the utility technical adviser:

  • A consistent headcount ratio. The taxpayer allocates MSC between transmission and distribution (T&D) and other departments and between production and nonproduction activities within a T&D department based on a headcount ratio that is consistently applied across all service departments, is redetermined annually, and in which the denominator includes only those who actually benefit from the MSC.
  • A production cost ratio with a limited reduction for purchase power. The taxpayer allocates the portion of MSC subject to allocation among production activities according to a production cost ratio that is computed as described in the IDD.

However, the IDD lists the following MSC allocation methods as examples of those that the LMSB considers relatively more significant for compliance priorities:

  • Generation departments in the MSC pool. The taxpayer asserts that a department that exclusively supports a production activity qualifies as an MSC department merely because the department incurs a cost that is deductible under Regs. Sec. 1.263A-1(e) (3)(iii) (e.g., the department acquires property qualifying for the deduction under Sec. 174 or sustains a casualty or theft loss deductible under Sec. 165).
  • Additional costs of working in an energized environment treated as costs of maintaining electric service. The taxpayer asserts that the additional costs of working more slowly in an energized environment are to be capitalized as costs of maintaining electric service instead of being capitalized to the cost of self-constructed assets. The taxpayer argues that these costs are analogous to the cost of temporarily relocating lines in Rev. Rul. 73-203 (see TAM 200811021).
  • Overly broad or other inappropriate cost drivers. The taxpayer uses cost drivers that are overly broad or inappropriate, such as those that result in the allocation of MSC to departments that receive no benefit from the MSC.
  • Imputation of production costs based on hypothetical events. The taxpayer uses a production ratio based on the estimated cost that would have been paid for generating power instead of purchasing power or an estimated headcount based on the number of employees that would have been required to generate the electricity instead of purchasing it.

The IDD states that members of an issue specialization team will perform the risk analysis of the MSC issue. Upon identifying an MSC issue in a Phase II case, examiners are required to contact the team for instructions to ensure proper and consistent application of LMSB guidance.


Contractual allowance: Under its issue-tiering strategy, the LMSB moves an issue from active status in its tier to a monitoring status in the same tier once the issue has been fully developed and a resolution strategy has been prepared. The fact that the LMSB has moved the Tier II contractual allowance issue to monitoring status indicates that the relevant issue management team has provided the necessary direction to the examiners, issued appropriate procedural guidance and legal position, and developed a resolution strategy. Taxpayers should note, however, that examiners will still receive issue guidance and support from the LMSB health care technical advisers and will still be required to follow direction provided in the September 2007 IDD on that issue. That directive and its related guidelines provide a uniform format and approach for examiners to evaluate potential compliance risk related to the issue, outline the established issue management and oversight process, and provide audit guidelines.

Super CCM: The directive on the Tier II super CCM provides the LMSB’s positions on when a taxpayer is eligible to use the CCM and when the contract is considered complete. Taxpayers that have taken positions inconsistent with the positions articulated in the directive should review the audit techniques described in the directive, as well as the pro forma IDRs and Forms 5701, in order to be prepared for any information an examiner is likely to request and the positions he or she is likely to assert.

Mixed service costs: The IRS designated the allocation of mixed service costs under Sec. 263A as a Tier I issue in response to a number of large taxpayers (mostly utilities) filing requests to change their method of accounting for mixed service costs from a facts-and-circumstances method to the simplified service cost method (SSCM) beginning in 2001. For many of these taxpayers, application of the SSCM resulted in a significant undercapitalization of costs allocable to selfconstructed assets. The LMSB released an IDD in May 2007 that divided the Tier I mixed service cost issue into two phases (LMSB-04-0207-013). Phase I dealt with tax years ending before August 2, 2005, and focused on whether self-constructed assets qualify as eligible property for the SSCM. Phase II dealt with tax years ending on or after August 2, 2005, for which regulations prospectively address the issue of eligibility. A June 2009 IDD moved Phase I cases to monitoring status, though the status of Phase II cases remains active (LMSB-4-0509-022).

The latest directive’s classification of MSC allocation methods as relatively more or less significant for compliance priorities highlights the LMSB’s strategy of allocating limited examination resources to the areas that pose a greater compliance risk. As a result, the methods that were listed as relatively less significant will likely not be challenged, while examination resources will be focused on the methods listed as relatively more significant.


David Kautter retired from Ernst & Young LLP in Washington, DC, in December 2009.

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

For additional information about these items, contact Mike Dell at (202) 327-8788 or

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