Check whether the specific termination rule applies
A business that reported income under percentage-of-completion accounting can face a different tax calculation when its customer cancels before completion. Section 1.460-4(b)(7) addresses a terminated long-term contract where the taxpayer retains ownership of the property that was the subject of the agreement. The rule reverses prior contract recognition and establishes a basis for the retained property. It does not treat every cancellation as an ordinary bad-debt deduction.
Establish the actual termination year, whether the contract was incomplete, which property remains owned by the business, and what consideration the business may retain. Collect the executed agreement and cancellation settlement before computing the adjustment. A customer that simply stops answering messages may have created a collection problem without establishing the specific termination facts. Likewise, a completed job with unpaid receivables presents a different question.
Reconcile the previously recognized amounts
Assume a manufacturer entered a qualifying long-term contract in a prior year and properly used the percentage-of-completion method. Through that prior year, it reported $360,000 of cumulative gross receipts and deducted $300,000 of cumulative allocable contract costs. Its cumulative recognized contract income was therefore $60,000. The customer terminates the unfinished contract in 2026, and the manufacturer retains ownership of the partially completed equipment.
Under the assumed applicable termination rule, the reversal is $300,000 of previously reported allocable costs minus $360,000 of previously reported gross receipts, producing a $60,000 loss in 2026. At a stipulated 21 percent federal rate with sufficient taxable income and no other restriction, that reversal reduces current tax by $12,600. The example reverses the prior recognized margin; it does not deduct the equipment's entire accumulated cost while leaving the equipment available for sale.
The calculation needs the actual tax reporting history rather than only cumulative invoices or book revenue. If the business had recognized different amounts for financial statements, preserve a reconciliation identifying those differences. Do not amend a correctly reported earlier year merely because the customer's later cancellation changed the economic outcome. The stated regulation places the reversal in the termination year.
Determine the basis of what the business keeps
Continue the example by assuming the manufacturer incurred another $80,000 of properly allocable production costs in 2026 and retains a $25,000 customer deposit under the cancellation settlement. The regulation's retained-property basis begins with the cumulative costs previously reported, adjusted for retained customer consideration. On the stated facts, $300,000 less the retained $25,000, plus the additional $80,000 of capitalizable production costs, leaves $355,000 of basis.
If the equipment is later sold for $400,000 with no further costs or adjustments, the simplified later margin is $45,000. This future sale calculation uses the carried property basis, not a zero basis created by treating every production payment as a current deduction. Across the two events, the business preserves the relationship between its actual production spending, customer deposit, and ultimate selling price.
The example assumes the deposit is properly retained and valued at $25,000 and does not exceed the relevant basis amount. The regulation requires income recognition when retained consideration exceeds the applicable basis after the permitted reduction. Refundable amounts, property received instead of cash, litigation settlements, and additional compensation require their own factual classification. Do not call every amount in the cancellation wire a deposit simply to obtain the desired result.
Close the old contract and open the retained-property file
Retain prior return schedules, completion factors, cumulative reported receipts and costs, current-year production records, the termination agreement, deposit ledger, and a physical description of the retained property. Reconcile the old contract schedule to the new asset or inventory schedule so no cost disappears or is counted twice. Identify later repair, finishing, storage, and selling costs separately and determine their treatment under the applicable rules.
The specified termination rule also excludes the terminated contract from the look-back method. That conclusion belongs in the closeout memorandum with the reason the rule applies, rather than an unexplained decision to omit a form. If ownership transferred, performance was completed, or the arrangement was assigned rather than terminated, review the different provisions before applying this result.
Update both operating forecasts and tax reserves. The canceled order may remove an expected collection while creating a reusable asset and a current tax reversal. A deduction does not replace the missing customer's cash. Assign responsibility for selling or repurposing the retained equipment, and give the next preparer its basis history along with the original cancellation records.
Sources & further reading
Consult the original guidance and its effective dates. These references support the educational discussion; their application depends on the specific facts.