An Update on Our Take on the Shea Homes Decision Now That the U.S. Court of Appeals Has Weighed In
2016-Issue 29 – On August 24, 2016, the U.S. Court of Appeals affirmed the Tax Court decision in Shea Homes Inc. v. Commissioner, 142 T.C. No. 3 (Feb. 12, 2014). This opinion is one of the few recent significant taxpayer-favorable decisions, and its impact could be significant not just for homebuilders in similar situations. Shea Homes affirmed the taxpayer’s position that a builder of a master planned community consisting of residences and amenities could consider the entire project development costs, including amenities, for purposes of qualifying to use the completed contract method of accounting and the related timing of income recognition. As a result, the taxpayer was permitted to defer recognizing much of its income until the entire project was substantially complete. The Internal Revenue Service made several arguments to deny the taxpayer’s contention that it was entitled to the deferral, including the suggestion that the method of accounting did not clearly reflect income in the original proceeding. The Commissioner repeated many of the same arguments at appeals and introduced one additional argument, which attempted to limit the scope of the original opinion, that was rejected by the judges on its merits and as a procedural matter.
While we suspected the government would appeal the decision, we believed and continue to believe that the opinion at the Tax Court level is a well-reasoned opinion that carefully considers the government’s arguments and fully explains why the court held in favor of the taxpayer’s position on each issue. The appeals court seemed to agree and, therefore, we strongly suggest developers consider whether to follow Shea Homes for future home sales contracts where amenities are a significant component of the project and the buyer’s purchase decision was influenced by the presence of these amenities. For taxpayers not engaged in the homebuilding business, there are also important lessons to be learned from the court’s analysis of the facts, particularly as it relates to the idea that an accounting method must clearly reflect income. At the Tax Court level, Judge Robert Wherry seemed to demonstrate the elements of reasoning necessary to challenge IRS proposed adjustments where the Service is invoking its authority to make changes to clearly reflect income. At the appeals court level, the court noted that it “affirm(s) the Tax Court's decision that on the record before it, the Taxpayers ‘used a permissible method of accounting’ and ‘that method of accounting clearly reflect[ed] [their] income.’” Shea Homes, 142 T.C. at 106. While the IRS appears to continue to believe it has broad authority to mandate changes, this case and the cases cited by Wherry present a road map of sorts for taxpayers who want to challenge the Service’s authority under the “to more clearly reflect income” position.
In general, Section 460 of the Internal Revenue Code requires, with exceptions, the use of the percentage of completion method (PCM). Under PCM, a taxpayer is permitted to deduct, as incurred, direct and indirect costs allocable to the contract, but also must report that portion of the estimated contract price that is proportional to the total estimated costs of the contract. PCM permits (requires) the deferral of recognition of any contract revenue until the conclusion of the contract, but also prevents the deductibility of any costs incurred until the related contract revenue is recognized.
However, Section 460 provides an exception for qualifying homebuilders that authorizes the use of the completed contract method (CCM) of accounting. The completed contract method allows taxpayers in the case of income and requires taxpayers in the case of a loss to defer recognition until the earlier of (a) when the customer uses the contract's subject matter for its intended purpose and the taxpayer has incurred at least 95 percent of the total allocable contract costs (Reg. Sect. 1.460-1(c)(3)(i)(A)) or (b) when there is final completion and acceptance by the customer (Reg. Sect. 1.460-1(c)(3)(i)(B)). To be eligible for the homebuilder exception, a taxpayer must reasonably expect at least 80 percent of the total contract costs to be attributable to the construction, reconstruction, rehabilitation or installation of any integral component of certain residential real property. More specifically, the homebuilder exception applies only to activity that relates to a dwelling unit contained in a building with four or fewer total units and to improvements on the site of the dwelling units. Thus, it may be problematic for communities with condominiums to use the completed contract method for that portion of the project.
In Shea Homes, the taxpayer took the position on its tax returns that final completion and acceptance under Treas. Reg. Sect. 1.460-1(c)(3)(i)(B) does not occur until the last road is paved and the final performance bond required by state and municipal law is released; therefore, the use and 95 percent completion test under Treas. Reg. Sect. 1.460-1(c)(3)(i)(A) applied. The Internal Revenue Service argued that the subject matter of the taxpayer’s contracts consisted only of the houses and the lots upon which the houses were built. Under the Service’s interpretation, the contract for each home met the final completion and acceptance test when the escrow closed for the sale of each home. Therefore, the dispositive issue in Shea Homes was whether roads and other community amenities were properly considered as part of the individual home contracts for purposes of Section 460.
It is significant that in Shea Homes, the court primarily considered the overall economic arrangement on the whole to determine whether it was appropriate and accurately reflected income. The Tax Court agreed with the taxpayer’s position that the relevant subject matter of the home contracts included the specific house, the lot, improvements to the lot and common improvements to the development. The amenities of the development, including other houses in the development, were a crucial aspect of the taxpayer's sales effort, the local government’s decision to approve the development and the buyers' decision to purchase houses in the development. Further, the Shea Homes court noted that local law in the states in which the taxpayer operated provided that a buyer purchases the right to use an allocable portion of common improvements as part of the home contract, whether or not the improvements were expressly included in the home purchase and sale contract. Accordingly, the Tax Court held that the community amenities were an essential element of the home purchase and sale contract, and thus properly includable in the consideration of whether the requirements for completion had been met.
It is worth noting that the court highlighted the fact that the community was a “lifestyle community” where a large part of the overall cost of developing the community related to the planned amenities. However, it is unclear how significant this issue was to Shea Homes’ factual analysis or its ultimate holding. The court’s logic in Shea Homes may apply to any type of community where amenities or common improvements are significant.
In addition to rejecting the notion that amenities and other houses should always be excluded from the calculation of total costs for purposes of the completed contract method’s 95 percent test, Shea Homes rejected the government’s position that the taxpayer’s interpretation of the statute would violate the requirement that a taxpayer’s overall method of accounting must clearly reflect income. The court held that the application of the completed contract method clearly reflected the taxpayer’s income because, among other things, Congress intended to provide significant income tax deferral to homebuilders to facilitate longer projects with high up-front costs associated with land acquisition, entitlement and development. In fact, the appeals court took notable exception to the fact that the Commissioner argued that Congress did not intend for the rules to be applied in the taxpayer’s manner even though he cited no authority. Therefore, this analysis may suggest that the courts believe that statues should not be interpreted narrowly and that the context in which Congress promulgated the rules should be taken into consideration and given significant weight.
In addition to maintaining its position that the overall method of accounting did not clearly reflect income, the Commissioner introduced a new argument related to the application of the special rules provided to homebuilders under the completed contract method. The appeals court opinion explains that:
The Commissioner concedes that the Tax Court correctly held that the subject matter of the Taxpayers’ home construction contracts includes more than just the house and lot purchased. He accepts the notion that the subject matter of the contract also includes the common improvements of the planned community development in which the house is situated, which improvements the Taxpayers are contractually obligated to build. But the Commissioner now takes issue with how the Taxpayers applied the 95 percent test. During the relevant tax years, the Taxpayers deemed their home construction contracts complete for purposes of the CCM when they had incurred 95 percent of the budgeted costs for building the entire community, including the costs of building all of the houses in the community. See 26 C.F.R. § 1.460-1(c)(3)(i)(A). In the Commissioner's current view, the subject matter of the contract includes the house, lot and common amenities, but does not include the other houses in the community. Accordingly, he argues that the 95 percent test should be met when the Taxpayers incur 95 percent of the budgeted costs of the contracted-for house, lot and common amenities, but not the costs of the other houses.
Fortunately, the appeals court rejected this theory in the majority opinion for the same reasons the Tax Court rejected the original argument related to the application of the regulations. (It is worth noting that one of the three judges believed the argument had merit but rejected it on procedural grounds since it was not proffered at the original trial.) The appeals court concluded that “this was not a simple case of buyers purchasing homes and having no substantial interest in whether the development would be and remain the kind of development that they wished to live in for some time in the future.” As a result, the majority concluded that the completed contract method could include the costs of the other houses. However, the court did caution future taxpayers from attempting to defer the costs indefinitely.
Alvarez & Marsal Taxand Says:
Broadly, the opinion in Shea Homes provides insight into how the courts view the concept of whether an accounting method clearly reflects income and suggests that the government may not have broad authority to apply a narrow interpretation to all statutes. Specifically, taxpayers that would consider applying the completed contract method after Shea Homes must consider the fact that Treas. Reg. Sect. 1.460-4(g) requires a taxpayer to treat similar contracts similarly unless it has obtained permission from the Internal Revenue Service to change its accounting method. This limited ability to change accounting methods may make it difficult for taxpayers to switch to a new approach for a project that is already underway. Relevant analogous guidance appears split on whether a taxpayer that has been recognizing income as of the date of each home closing has adopted a method of accounting that it must continue (unless the Internal Revenue Service grants permission to change the method) or whether the existing approach represents an error in the application of the completed contract method that can be corrected by filing amended tax returns for open tax years. Given that each home contract is a separate contract, the taxpayer may also be able to apply the completed contract method to future sales at ongoing development projects by making a material change to the terms of its future home contracts such that these future contracts are more closely linked to the completion of community benefits. However, this may give rise to unwanted non-tax business issues that may be prohibitive.
Finally, even if a taxpayer does not want to make any changes with respect to its active development projects, a homebuilder may use the completed contract method for future phases of a development project or for future projects by using a new entity for those projects. This new entity would then adopt the completed contract method in its initial tax year. Homebuilders should carefully analyze how Shea Homes may apply to their specific facts and circumstances in order to reap the potential benefits from this potentially favorable development. But homebuilders should also be wary of the fact that the completed contract method could be a double-edged sword if a project operates at an overall loss, since its application could result in a deferral of the losses. Other taxpayers may be well advised to read the Shea Homes case for insight into reasoning and support when challenging the Service’s proposal to adjust the treatment of items to “more clearly reflect income.” Its authority is broad for sure, but not boundless and above suspicion as explained in Shea Homes by both the Tax Court and the appellate court.
Written by Tyler Horton
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.
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