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the regulations at section 1.451-3(d)(6), Income Tax Regs., to
allocate costs to a long-term contract.17
The regulations provide that direct material and direct
labor costs attributable to a long-term contract must be
allocated to that long-term contract.18 Sec. 1.451-3(d)(6)(i),
Income Tax Regs.; see also sec. 1.451-3(d)(5), Income Tax Regs.
Indirect costs, those costs other than direct material and direct
labor costs, are subject to two levels of allocation.19 See sec.
1.451-3(d)(6)(ii), (8)(iv), Income Tax Regs.
In the first level allocation, the regulations recognize
that some indirect costs benefit both long-term contracts and
“other activities of the taxpayer.” Sec. 1.451-3(d)(6)(ii),
Income Tax Regs. “Accordingly, such costs require a reasonable
allocation between the portion of such costs that are
17 The Commissioner issued regulations pursuant to sec.
460, applicable to contracts entered into on or after Jan. 11,
2001. Sec. 1.460-1(h)(1), Income Tax Regs. These regulations do
not apply to the instant case.
18 Direct material costs are costs of materials that have
“become an integral part of the subject matter * * * and those
materials which are consumed in the ordinary course of building,
constructing, installing or manufacturing the subject matter”.
Sec. 1.451-3(d)(6)(i), Income Tax Regs. Direct labor costs are
the costs of labor that “can be identified or associated with a
particular * * * long-term contract.” Id.
19 The regulations under secs. 460 and 263A do not use the
terminology “first level” and “second level” allocations.
However, the effect of those regulations is to break the
allocations into two distinct steps. For purposes of clarity, we
refer to these steps as “first level” and “second level”.
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