Announcement 2024-40: A gift and a curse?

Editor: Mary Van Leuven, J.D., LL.M.

In late 2024, the IRS released Announcement 2024–40, addressing certain federal income tax implications for taxpayers constructing advanced manufacturing facilities funded in part through grant agreements with the government under the CHIPS Act of 2022, Division A of the CHIPS and Science Act, P.L. 117–167 (CHIPS grant agreements).

The announcement states that expenses covered by grant funds may be “qualified investments” for purposes of the advanced manufacturing investment credit under Sec. 48D. This is advantageous for taxpayers seeking the Sec. 48D credit, as more qualified investments generally mean a higher credit.

However, the announcement also clarifies that CHIPS grant agreements do not qualify as long–term contracts under Sec. 460. While Announcement 2024–40 is ostensibly taxpayer–favorable, the conclusions regarding Sec. 460 may cause heartburn for taxpayers undertaking construction activities with government–provided funds.

Income and deductions generally

For federal income tax purposes, under Sec. 61, gross income includes “all income from whatever source derived.” Courts have interpreted this to mean that gross income includes “accessions to wealth, clearly realized, and over which the taxpayers have complete dominion” (Glenshaw Glass Co., 348 U.S. 426, 431 (1955)). This means that to exclude the receipt of money or property from income, an explicit provision of the Code or other applicable law must provide for the exclusion.

While Sec. 61 determines whether an item is included in gross income, Sec. 451 generally governs when the item is included in income. Under this section, a cash–method taxpayer recognizes income in the year received, while an accrual–method taxpayer recognizes income in the year the right to the amount becomes fixed and determinable with reasonable accuracy (generally, the earliest of the year received, earned, due, or recognized in certain specified financial statements; see Regs. Secs. 1.451–1 and 1.451–3).

Liabilities, on the other hand, are subject to their own set of rules. Sec. 461 generally takes liabilities into account in the year paid (cash–method taxpayers) or the year incurred (accrual–method taxpayers). A liability is incurred in the year it becomes fixed and determinable and economic performance has occurred (see Sec. 461(h) and Regs. Sec. 1.461–4 for a discussion of the economic–performance rules).

A cost may be taken into account through a current–year deduction or, if another provision requires it, through capitalization and recovery through depreciation, amortization, cost of goods sold, etc. For example, Sec. 263(a) mandates capitalizing certain costs to acquire or produce property, while Sec. 263A extends this requirement to a larger subset of costs attributable to self–constructed property and property produced or acquired for resale. Costs capitalized under either of these provisions are included in the basis of the underlying property acquired or produced and are generally recovered via depreciation or amortization, upon asset disposition, or through cost of goods sold (see Regs. Sec. 1.263(a)-2(h)).

The following example illustrates how the application of these rules can cause a mismatch whereby income is recognized in a year prior to recovering allocable costs:

Example: On June 1, 2024, Taxpayer (a calendar–year, accrual–method taxpayer) and Customer enter into a contract under which Taxpayer agrees to produce an item of machinery (X) for Customer in exchange for $1,000. The contract requires Customer to pay Taxpayer the full purchase price by Dec. 1, 2024. Taxpayer estimates that it will cost $900 to produce X. During 2024, Taxpayer incurs $450 of production costs and in 2025 incurs the remaining $450 of production costs. On May 1, 2025, Taxpayer completes production and transfers ownership of X to Customer.

Applying the general rules discussed above, Taxpayer will recognize $1,000 of taxable income in 2024. Although Taxpayer also incurred $450 of production costs in 2024, Taxpayer must capitalize those costs to X’s basis under Sec. 263A. In 2025, when ownership of X is transferred to Customer, Taxpayer can recognize the $900 of production costs (note that certain optional rules regarding advance payments and cost offsets in Sec. 451 and related regulations may mitigate this result, but those provisions are beyond the scope of this item).

Another option

An exception to the general rules of Secs. 451 and 461 applies to long–term construction contracts required to be accounted for under the percentage–of–completion method (PCM) of Sec. 460.

Under the PCM, revenue (i.e., the contract price) is recognized over time as the taxpayer incurs allocable contract costs. To ensure that the taxpayer each year recognizes a net amount that approximates the taxpayer’s profit or loss on the contract, the PCM generally requires that allocable contract costs be deducted from taxable income as incurred. Accordingly, Secs. 263(a) and 263A exclude from their scope allocable long–term contract costs under Sec. 460.

Applying the PCM to the preceding example, in 2024 when the contract is 50% complete, Taxpayer would recognize $50 of net taxable income related to the contract ($500 of revenue minus $450 of allocable contract costs). In 2025, when the contract is complete, Taxpayer will recognize the remaining contract price ($500) and will deduct the production costs incurred in that year ($450), for net taxable income of $50.

Application to grant proceeds

A taxpayer receiving grant proceeds generally must recognize the proceeds as taxable income. Under the general rule of Sec. 451, the taxpayer will likely be taxed on the income no later than the year the proceeds are received. However, when these proceeds are allocated toward construction activities or the acquisition of fixed assets (which may be required under the terms of the grant agreement), the taxpayer cannot deduct such costs and must instead capitalize them to the produced or acquired assets. For real property construction costs, this typically means recovery through depreciation deductions over a 15-, 20-, or even 39–year period (Sec. 168).

Long-term construction contracts

A long–term construction contract spans more than one tax year and involves building, reconstructing, or improving real property. The primary factor in determining whether a long–term contract is a Sec. 460 long–term construction contract is whether construction activities are essential to fulfilling the taxpayer’s obligations under the contract. Crucially, Regs. Sec. 1.460–1(b)(2)(i) provides:

If a taxpayer has to … construct an item to fulfill its obligations under the contract, the fact that the taxpayer is not required to deliver that item to the customer is not relevant. Whether the customer has title to, control over, or bears the risk of loss from, the property manufactured or constructed by the taxpayer also is not relevant. Furthermore, how the parties characterize their agreement (e.g., as a contract for the sale of property) is not relevant.

The IRS has previously reflected a broad interpretation of this language, albeit in nonreliance guidance. In Letter Ruling 202318008, the IRS determined that a taxpayer was required to recognize revenue and expenses relating to certain construction activities under the PCM, notwithstanding that the constructed property was intended to, and did, remain in the taxpayer’s ownership. The facts indicate that the taxpayer was required, as part of its contract with its customer, to relocate certain of its facilities to remove a customer–owned item. Construction activities included demolishing a portion of the building and adding on to another portion of the same building and a second nearby building. The taxpayer was compensated through a reimbursement of its allocable costs, without any profit markup.

The IRS ruled that the contract was a Sec. 460 long–term contract requiring use of the PCM, noting that it is irrelevant who owns the constructed property, so long as the taxpayer is required to construct the property to fulfill its contractual obligations. Although not explicitly described in the letter ruling, because the contract price effectively equaled the associated costs, the taxpayer presumably recognized zero net taxable income in each year of the contract under the PCM.

Announcement 2024-40

Despite Letter Ruling 202318008, in Announcement 2024–40, the IRS has arguably narrowed its view of the scope of Sec. 460, implying that there must be an intended (if not an actual) transfer of property or benefits under a contract in order for that contract to be treated as a long–term contract.

Announcement 2024–40 confirms that amounts paid or incurred for the construction, expansion, or modernization of advanced manufacturing facilities pursuant to CHIPS grant agreements are included in the cost basis of the constructed property and therefore may be eligible for the Sec. 48D credit (equal to 25% of the cost basis, or “qualified investment,” of credit–eligible property).

As part of this, the IRS concluded that these agreements are not eligible for the PCM, reasoning that Sec. 460 and related Treasury regulations “contemplate an agreement with a customer for the construction of the ‘subject matter’ of the contract and payment of a ‘contract price’ as compensation for the ‘subject matter’ of the contract.” According to the IRS, a taxpayer receiving funds under a CHIPS grant agreement “is constructing the facility on its own behalf,” and the award typically does not fully compensate the taxpayer for the cost of the project (or provide a return).

Potential timing gap between grant income and recovered costs

While not surprising, the IRS’s conclusion in the announcement may be result–driven.

Treasury regulations under Sec. 460 clearly provide that the transfer of property is not relevant in qualifying a contract as a long–term contract. Although grants are often viewed as “free” money, to obtain grant funds under the CHIPS Act and similar legislation, the taxpayer and the applicable agency execute an agreement providing for the payment of funds in exchange for the taxpayer’s promise to engage in specified activities. To the extent these include construction activities, the taxpayer must undertake those construction activities to fulfill its contractual obligations.

By covering all or a portion of the taxpayer’s costs, the grant effectively compensates the taxpayer for its construction activities to the extent of the grant award. Although the government–grantor is not a “customer” in the sense that it is not purchasing a good or service that will directly benefit it, it is unclear whether this customer standing is required in light of the explicit decision not to require that the contracting party receive ownership of goods under the contract.

The announcement benefits taxpayers claiming the Sec. 48D credit but poses challenges that, if adhered to, could create a timing gap between recognizing grant income and recovering costs. While the announcement’s guidance is not mandatory, recipients of construction–related grants should consult their tax adviser to assess the impact and evaluate the risks of taking a taxpayer–favorable position contrary to the IRS’s view.

Editor Notes

Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.

For additional information about these items, contact Van Leuven at mvanleuven@kpmg.com.

Contributors are members of or associated with KPMG LLP.

The information in these articles is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of Section 10.37(a)(2) of Treasury Department Circular 230. The information contained in these articles is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. The articles represent the views of the authors only and do not necessarily represent the views or professional advice of KPMG LLP.