Appeals court confirms homebuilder's super completed contract method
TAX ALERT |
In February 2014, the U.S. Tax Court held that a group of home development companies (Shea Homes, Inc. and Subsidiaries, et al. v. Commissioner, 142 TC 60) were able to use the completed contract method of accounting to recognize revenue and expenses for long-term home construction contracts, utilizing the overall community development for purposes of determining contract completion, rather than the completion of each home. On appeal to the 9th U.S. Circuit Court of Appeals, Shea Homes Inc. et al. v. Commissioner, the appellate court upheld the taxpayer’s application of the completed contract method for long-term community construction contracts.
Generally, construction contracts that are not completed in the year that the contract begins must be accounted for under the percentage completion method of accounting (PCM). Under the PCM, taxpayers recognize revenue and expenses based on the contract price multiplied by the annual contract cost over total estimated project costs. However, for home construction contracts1 taxpayers are permitted to use an alternative method of accounting—the completed contract method (CCM). Pursuant to the CCM, taxpayers recognize revenue and expenses in the ‘completion year’ of the contract—defined as the earlier of when: 1) 95 percent of the total allocable contract costs have been incurred, or 2) the subject matter of the contract is completed and accepted. This usually presents a revenue deferral opportunity for taxpayers engaged in long-term real estate development for residential use due to the timing of incurring development and construction expenses, compared to when contracts are actually completed or 95 percent of costs have been incurred.
In Shea, a group of residential development companies applied the 95 percent cost test to include an entire planned development’s costs (effectively expanding this test beyond the completion of a contract for a specific unit), which included the construction of community infrastructure, amenity facilities, homeowner’s association rights, and other common-use features available to the community, not just specific homes. The taxpayer marketed the community features and lifestyle, asserting that the subject matter of each individual contract included the overall community development and therefore delaying the 95 percent test until the overall community was nearly completed. The IRS audited the taxpayer and asserted that the 95 percent test should be applied to each individual home contract and that the community development fell outside the scope of the individual home contracts as secondary items. The U.S. Tax Court sided with the taxpayer, agreeing that the overall community development was what buyers bargained for in their contracts, and that all documents represented this concept, which clearly reflected the taxpayer’s income.
Upon appeals, the IRS argued that the 95 percent test should be applied towards the house, lot and common amenities, but not other houses in the community (as the taxpayer was applying). The 9th Circuit disagreed, stating that each person in the community would have a vested interest in the use of the entire community’s property in assuring that the advertised planned lifestyle is followed to some degree.
It should be noted that a broad brush application of this ruling would be improper—the 9th Circuit itself cautioned taxpayers that the underlying facts and circumstances dictate the subject matter of a contract. Therefore, homebuilders and residential developers would be remiss to defer income recognition under the 95 percent test to the entire community without further examination of the specific contract terms. Accordingly, while the Shea appeals decision is a taxpayer win, taxpayers should consult their tax advisors to determine proper application of the CCM related to the specific contract facts and circumstances.
 Contracts for the construction of residential buildings consisting of four or fewer dwelling units where 80 percent or more of the estimated contract costs are for the dwelling units and improvements to real property directly related to such units. See section 460(e)(6).