IRS disagrees with the Court of Appeals for the Ninth Circuit on when a.. “developer recognizes income under a completed contract method.
IRS has announced its nonacquiescence with the holding of the Court of Appeals for the Ninth Circuit in Shea Holmes, which affirmed the Tax Court, that concluded that taxpayers who developed large, planned residential communities had used a permissible accounting method that clearly reflected their income. The taxpayers maintained that completion and acceptance under the completed contract method of accounting under Code Sec. 460 did not occur until the common improvements and amenities were completed.
Background. Under the completed contract method (CCM), gross contract price and allocable contract costs are taken into account upon contract completion. Contract completion occurs upon the earlier of:
- The customer’s use of the subject matter of the contract and taxpayer having incurred 95% of the estimated allocable contract costs attributable to the subject matter (the 95% completion test); and
- Final completion and acceptance of the subject matter. (Reg. § 1.460-1(c)(3)(i))
The regs also provide that completion is determined without regard to whether “secondary items” have been used or finally completed and accepted. (Reg. § 1.460-1(c)(3)(ii))
Facts. Shea Homes, Inc. and Subsidiaries (Taxpayers) constructed and sold houses in residential developments. Taxpayers also constructed common improvements. These improvements included infrastructure, such as sewers and roads, and amenities, such as parks and clubhouses. Taxpayers entered into separate purchase and sale agreements (home construction contracts) with individual buyers. Taxpayers used the CCM set out in Reg. § 1.460-4(d) to account for the income and costs of their home construction contracts.
For purposes of determining when their home construction contracts were completed, Taxpayers treated an entire development or phase of a larger development as the subject matter of each individual home construction contract. Thus, in applying the 95% completion test to a contract, Taxpayers took into account the estimated costs of the entire development or phase, including the costs of constructing houses that were the subject matter of other contracts. Taxpayers deferred recognition of income from all house sales in a development or phase until they had incurred 95% of the estimated costs of the entire development or phase.
On audit, IRS challenged this treatment and asserted that income from Taxpayers’ home construction contracts should be reported at the time of sale, because that was when there was final completion and acceptance of the subject matter of the contract, or, in the alternative, at final completion and acceptance of all but uncompleted secondary items.
Tax Court decision. The Tax Court rejected IRS’s arguments
- That the subject matter of an individual home construction contract consisted solely of a house and the lot on which the house was situated, and
- Alternatively, that common improvements, although a part of each contract’s subject matter, were secondary items, so that a contract was completed upon the sale of a house, when the sole or primary subject matter of the contract had been finally completed and accepted.
The Tax Court found for Taxpayers. (Shea Homes, Inc. and Subsidiaries, et al, (2014) 142 TC 60142 TC 60, see Weekly Alert ¶ 20 02/20/2014) IRS appealed.
Appellate decision. The Ninth Circuit affirmed the Tax Court decision. The Court stated, “[T]he Tax Court determined that, as a matter of fact, the subject matter included the house, the lot, ‘the development…and its common improvements and amenities'” (quoting the Tax Court opinion).
The Court reviewed the Tax Court’s conclusions of law and mixed questions of law and fact de novo (anew). A mixed question of law and fact is one in which the primary facts are undisputed and ultimate inferences and legal consequences are in dispute. The Court reviewed the Tax Court’s findings of fact for clear error. The Ninth Circuit declined to reverse what it considered the Tax Court’s factual finding that the subject matter of each home construction contract consisted of the entire development or phase in which a house was situated.
Accordingly, the Court held that Taxpayers’ method of determining contract completion was proper. (Shea Homes, Inc. and Subsidiaries (CA 9 8/24/2016)
IRS disagrees. IRS disagrees with the Ninth Circuit’s conclusion that the 95% completion test can properly be applied with reference to the costs of an entire development or phase. IRS found that the Ninth Circuit reviewed the Tax Court decision under a clearly erroneous standard. The Court shouldn’t have approached its review as if was evaluating a factual finding by the Tax Court; the Court should have examined whether the Tax Court correctly interpreted and applied the applicable the Code and regs.
In the AOD, IRS explained that its position is that, under the regs, contract completion and the 95% completion test must apply on a contract-by-contract basis. It reasoned that the latter considers “the total allocable contract costs attributable to the subject matter [of the contract]”. (Reg. § 1.460-1(c)(3)(i)(A)) The total costs of an entire development or phase cannot be the “allocable contract costs” of each individual home construction contract. Reg. § 1.460-4(d)(1) provides that “a taxpayer using the CCM…must take into account in the contract’s completion year…the gross contract price and all allocable contract costs incurred by the completion year”. If the “allocable contract costs” of a contract are the entire cost of a development or phase, this same set of costs becomes deductible multiple times as each and every individual home construction contract is completed.
This is a great opportunity for CPA’s with contractor clients to review this new planning opportunity.
Be careful with you fact pattern …but this may be an option for planning in the future.