Editor: Mary Van Leuven, J.D., LL.M.
In Shea Homes, Inc., 142 T.C. No. 3 (2014), the Tax Court held that, in applying the completed-contract method to the construction and sale of homes in a master planned community, the taxpayers could treat the contracts as incomplete until 95% of each contract's costs, including an allocable share of amenity and common improvement costs, were incurred. The Tax Court rejected the IRS's argument that amenities and common improvements should be excluded for this purpose and instead concluded that the subject matter of the contracts properly consisted of both the home and the larger development, including the amenities and other common improvements, and was not limited simply to the house and the lot on which it sat.
Sec. 460(a) generally requires taxpayers to use the percentage-of-completion method to account for taxable income from a long-term contract. This method requires a taxpayer to recognize income and expenses throughout the duration of a contract. A long-term contract is a contract for the manufacture, building, installation, or construction of property that is not completed within the tax year during which the contract is entered into (Sec. 460(f)(1)). Home construction contracts are an exception to this general rule (Sec. 460(e)(1)(A)). Taxpayers that qualify for this exception can use methods such as the completed-contract method (Regs. Sec. 1.460-4(d)), which allows taxpayers to defer recognition of allocable income and expenses until the contract is completed.
A home construction contract is a construction contract for which at least 80% of the estimated costs, as of the close of the tax year in which the contract is entered into, are reasonably expected to be attributable to the building, construction, reconstruction, improvement, or rehabilitation of, or the installation of any integral component to, dwelling units and improvements to real property directly related to and located on the site of such dwelling units (Sec. 460(e)(6)(A)). Regs. Sec. 1.460-3(b)(2)(iii) instructs a taxpayer to "[include] in the cost of the dwelling units their allocable share of the cost that the taxpayer reasonably expects to incur for any common improvements (e.g., sewers, roads, clubhouses) that benefit the dwelling units and that the taxpayer is contractually obligated, or required by law, to construct within the tract or tracts of land that contain the dwelling units." In determining whether a contract qualifies as a home construction contract, taxpayers may include costs attributable to common improvements and development infrastructure in the estimated costs. However, the IRS and taxpayers have long disagreed as to whether these costs are included in the tests for determining the date a contract is complete.
Shea Homes is a developer of large, planned residential communities. It develops the land and constructs homes and common improvements, including amenities. For tax purposes, the company uses the completed-contract method of accounting. Shea Homes and the IRS disagreed as to whether common improvements and amenities the company constructs as part of its planned communities are included in the definition of "contract" and on how to determine the date a contract is complete. The corporation and related partnerships sought redetermination of deficiencies and review of final partnership administrative adjustments in the Tax Court, where their cases were consolidated.
The Tax Court agreed with Shea Homes' position that the contract should be defined as pertaining to a home and its larger development (which would allow a longer period of income deferral) and rejected the IRS's position that the contract should be defined as pertaining to the sale of each individual home (which would cause the period of income deferral to be shorter). Because the Tax Court agreed with Shea Homes' definition of the contract, the court also agreed that the contract completion date should be based on when the entire development is completed, not when the individual homes are completed. The 95% test (discussed below) applies to determine when the contract is completed; that is, the contract is not completed until the homes are used by the buyers for their intended purpose and at least 95% of the total allocable contract costs attributable to the subject matter (homes and common improvements) have been incurred. Because the Tax Court rejected the IRS's definition of the contract, it did not agree with the Service's position that the contract is complete when each home is sold because the "final completion and acceptance of the subject matter of the contract" test (discussed below) has been met at that point.
Documents Included in the Contract
Shea Homes' position was that it builds not just a home but a planned community, including infrastructure and amenities—homebuyers ostensibly are also buying a lifestyle. Shea Homes' marketing is geared toward selling the community and lifestyle, not just the homes. The home construction contracts it entered into with homebuyers included the sale of a lot, home, and interest in a development with amenities, infrastructure, and a homeowners association. Shea Homes maintained that this was evidenced by the purchase-and-sale agreement and the multiple documents (recorded maps and plats; municipal resolutions and conditions; public reports; covenants, conditions, and restrictions (CC&Rs); and homeowners association documents) that were appended to, or referenced in, the agreement. Before the buyer and Shea Homes could close escrow on a home, Shea Homes would be required to either construct all common improvement areas for the development (or phase) or post a bond.
The Tax Court found that the purchase-and-sale agreement alone was not the entire agreement between the parties. The purchase-and-sale agreement specifically included a checklist ensuring that the purchaser received the related documents discussed above. The court stated that purchasers of homes in Shea Homes' developments were conscious of the elaborate amenities and would have understood that the price they paid for homes included the development's amenities. The court found further evidence that Shea Homes was obligated to its lot purchasers for much more than just the purchase-and-sale agreement in the performance bonds that were required by state and municipal law to secure Shea Homes' completion of the common improvements in each development.
Homeowners associations for each development, as well as the municipalities and states in which the developments were situated, were identified as obligees in the performance bonds. Purchasers automatically become members of the homeowners association, and thus, each purchaser has certain rights as to enforcement of the bonds by the homeowners association. The court ruled that the purchase-and-sale agreements incorporate the other referenced documents, such as the public reports, the CC&Rs, the homeowners association documents, and even the publicly recorded maps and conditions of approval.
Subject Matter of Contracts and the Date Completed
In general, a long-term contract is completed upon the earlier of when (1) the customer uses the subject matter of the contract for its intended purpose (other than for testing) and the taxpayer has incurred at least 95% of the total allocable contract costs attributable to the subject matter (Regs. Sec. 1.460-1(c)(3)(i)(A)); or (2) final completion and acceptance of the contract's subject matter occurs (Regs. Sec. 1.460-1(c)(3)(i)(B)). Taxpayers apply these tests to determine when a contract is completed under the completed-contract method "without regard to whether one or more secondary items have been used or finally completed and accepted" (Regs. Sec. 1.460-1(c)(3)(ii)).
Based on its definition of the contract, Shea Homes maintained that the date the contract was complete should be determined by when the entire development was complete, not when the individual homes were complete. Shea Homes maintained that the 95% test is the applicable definition of when the contract is complete and that the contracts were not complete until the homes were used by the buyers for their intended purpose and it had incurred at least 95% of the total allocable contract costs attributable to the subject matter (homes and common improvements). Final completion and acceptance of each phase or development did not occur until the final road was paved and the final bond was released.
Because the 80% test for a home construction contract includes the allocable share of the costs of common improvements, the 95% test also must include these costs. Under its completed-contract method of accounting, if Shea Homes incurred costs equal to or greater than 95% of the budgeted costs, then it reported income for that tax year from homes that had closed in escrow up to that date. If the incurred costs did not exceed 95%, then it deferred any income from homes that closed in escrow that year.
Under the IRS's definition of the contract, the contract was complete when each home was sold; the "final completion and acceptance of the subject matter of the contract" test had been met at that point. The IRS maintained that at the closing of a home, Shea Homes had expended all costs to construct that home and improvements thereon. If the court would not agree with this position, the IRS asked it alternatively to hold that the common improvements were secondary items and did not preclude a contract from being completed when each home was sold.
The Tax Court agreed with Shea Homes that the regulations state that, in determining when a contract is begun and completed, "a taxpayer must consider all relevant allocable contract costs incurred and activities performed by itself, by related parties on its behalf, and by the customer, that are incident to or necessary for the long-term contract" (Regs. Sec. 1.460-1(c)(1)). Because the sale price in a home construction contract includes an allocable share of the cost of common improvements under Regs. Sec. 1.460-3(b)(2)(iii), the total allocable contract costs must also include the allocable share of common improvement costs. Therefore, the court determined that the contracts generally met the 95% completion test before they met the final completion and acceptance test. Under the completed-contract method of accounting, Shea Homes was entitled to defer income from its contracts until 95% of the total contract costs allocable to the subject matter of the contract were incurred on the development or the phase of the development was completed and accepted.
As for the IRS's position that the common improvements should be considered secondary items, the Tax Court found that the amenities were crucial to Shea Homes' sales effort, its ability to obtain governmental approval of the development, and the buyers' purchase decision. Thus, the court ruled that the amenities were an essential element of the home purchase-and-sale contract, not secondary items.
Summary and Practical Implications
The Tax Court properly concluded that the completed-contract method available to homebuilders should be applied to the entire subject matter of the contract. While this results in additional deferral of income, this deferral is inherent in the completed-contract method, which Congress explicitly allowed to homebuilders, while requiring most other businesses with long-term contracts to use the percentage-of-completion method.
The decision is a victory for homebuilders in general, but in particular for developers of master planned communities that are obligated to complete amenities and other common improvements.
Homebuilders who meet this profile should consider their options to apply the result of the decision if they are currently reporting income at the time of delivery of each home, which may include planning for new entities or filing a request to change their accounting method under the nonautomatic provisions of Rev. Proc. 97-27 (taking into account the IRS's current position on such changes and anticipated regulatory guidance). These accounting method changes would be applied on a cutoff basis to contracts entered into on and after the beginning of the year of change.
Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or email@example.com.
Unless otherwise noted, contributors are members of or associated with KPMG LLP. The information contained in this item is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This item represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP.