Victory for Homebuilders in Tax Accounting Stand-Off But IRS Fights Back

By Team HRH | June 7, 2017

In a significant case, homebuilders that want to realize income under the completed contract accounting method based on an entire development won a victory. However, the IRS recently responded by announcing that it generally wouldn’t follow the decision in cases involving other taxpayers (see further down).

The U.S. Court of Appeals for the Ninth Circuit upheld a lower court ruling affirming that a homebuilding group could defer tax under the completed contract method rather than use the percentage-of-completion accounting method.

IRS Formally Disagrees with Court Over Timing

On April 10, 2017, the IRS announced its “nonacquiescence” with the Ninth Circuit Court holding described in this article. In the case, the developers contended that final completion and acceptance didn’t occur until the last road was paved and the final bond was released. The IRS argued that final completion took place upon the sale of each home. IRS nonacquiescence means the tax agency doesn’t agree with a court’s ruling and generally won’t follow the decision in cases involving other taxpayers. (IRS Action on Decision 2017-03)

Background

A long-term contract covers the manufacture, building, installation, or construction of property, if not completed in the tax year in which the contract is signed. Although there are certain exceptions, contractors with these contracts generally must use the percentage-of-completion method, realizing income over time.

Under the regulations for long-term contracts, a job is complete on the earlier of:

  1.  When the subject matter of the contract is used by the customer for its intended purpose and at least 95% of the total allocable contract costs have been incurred by the taxpayer (the 95% test), or
  2. When there is final completion and acceptance.

With the completed contract method, however, contractors don’t report any income until a contract is complete, although payments are received before completion. The completion date is determined without regard to whether secondary items in the contract have been used or finally completed and accepted.

The completed contract method may be engaged instead of the percentage-of-completion method in home construction and other real property construction contracts if the contractor:

  • Estimates that the contracts will be completed within two years of the start date, and
  • Meets a $10 million gross receipts test.

A home construction contract is one where 80% or more of the estimated total contract costs is reasonably expected to be attributable to the building, construction, reconstruction, or rehabilitation of dwelling units contained in buildings containing four or fewer dwelling units, and to improvements to real property directly.

Facts of the Case

Shea Homes Inc. and several subsidiaries formed an affiliated group of corporations. The group built and sold homes in master planned community developments in Arizona, California and Colorado. The communities ranged in size from 100 homes to more than 1,000. The group’s business model emphasized the special features and amenities of master planned communities, which can include parks, golf courses, lakes, bike paths, and jogging trails.

The purchase price of each home included the building, lot, improvements to the lot, infrastructure and common area improvements, financing, fees, property taxes, labor and supervision, architectural and environmental design, bonding and other costs. Income from the sale of homes was based on completion of the entire development, rather than on the sale of each individual home. The IRS disagreed with the group’s use of that accounting method and assessed deficiencies. Eventually, the case went to court.

Round 1. The U.S. Tax Court looked at eight representative developments out of 114 that the group built during the tax years in question.

The group contended that completion and acceptance didn’t happen until the last road was paved and the final performance bond required by state and municipal law was released.

The IRS argued that the subject matter of the taxpayers’ contracts consisted only of the houses and the lots upon which the houses were built. Under the tax agency’s interpretation, the contract for each home met the completion and acceptance test when escrow was closed for the sale of each home. It also said that these contracts, which were entered into and closed within the same tax year, weren’t long-term contracts.

But the Tax Court upheld the group’s interpretation of the completed contract method. It also held that the subject matter of the contracts consisted of the home and the larger development, including amenities and other common improvements.

The court rejected the IRS argument that the subject of the contract was just the lot and the house, and that the common improvements in the development were only secondary items that didn’t affect completion of the contract.

Court’s Interpretation of the Primary Subject

The primary subject matter of the contracts included the house, lot, improvements to the lot, and common improvements to the development, the court ruled. The amenities were crucial to the sales effort and buyers’ purchase decisions as well as to obtaining government approval for the development. Accordingly, the amenities were an essential element of the home sales contracts.

Round 2: On appeal, the IRS tried a different argument. It conceded that the group’s home construction contracts encompassed more than just individual homes and lots and included common improvements of each planned community that the group was contractually obligated to build.

But it asserted that the group had applied the 95% test incorrectly.

The IRS argued that each contract pertained to the particular home and lot plus the common areas, but not the other homes in the community. By taking this approach, the IRS reasoned that the 95% test would be met only when the group incurred 95% of the budgeted costs of the home, lot and common amenities, but not the costs of the other homes.

The Ninth Circuit Court didn’t buy that argument. It said that the group’s application of the 95% test clearly reflected income because the purchasers of the homes were contracting to buy more than the homes’ mere “bricks and sticks.” They were paying a premium because they expected to enjoy benefits and a certain lifestyle from the community’s amenities.

Therefore, the Ninth Circuit affirmed the Tax Court’s decision. (Shea Homes, Inc., No. 14-72161, CA-9, 8/24/16).

Another Circuit Court Sided with the IRS

The IRS prevailed in a similar case, but with a couple of important differences.

The Fifth Circuit Court of Appeals upheld a U.S. Tax Court decision that a residential land developer’s sale and custom lot contracts constituted long-term construction contracts, but weren’t home construction contracts as defined by tax law. Thus, the developer couldn’t use the completed contract method.

There are two critical distinctions in this case from the Shea Homes case before the Ninth Circuit Court of Appeals:

  1. The taxpayer in this case wasn’t a homebuilder, but rather a land developer that sold finished lots to builders that sold the homes to consumers.
  2. The tax deferral resulting from the use of the completed contract method by the Shea group was, on average, less than five years. In contrast, the deferral period in the Fifth Circuit case was much longer in a number of instances. (Howard Hughes Company, LLC, 805 F.3d 175, CA-5, 10/27/15)

A Mixed Victory

Although this case signals a victory for homebuilders that want to realize income under the completed contract method based on an entire development (not the separate sales of individual homes), the IRS has formally announced it will generally not follow the decision in future cases with other taxpayers. Consult with your tax advisor about how to proceed in your specific situation.

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