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Ninth Circuit Finds Home Builder Properly Used Completed Contract Method


Synopsis
 
The U.S. Court of Appeals for the Ninth Circuit (Ninth Circuit) affirmed a decision by the U.S. Tax Court that residential home developers were allowed to use the completed contract method of accounting for home construction contracts under IRC §460.  Further, the Court held that the completed contract method clearly reflected the taxpayer’s income and the taxpayer could consider the entire project development costs including amenities.  The result of the Court’s ruling is that the taxpayer is able to defer recognizing income until substantially all of the project is complete. Shea Homes, Inc. v. Commissioner, No. 14-72161 (9th Cir. August 24, 2016)
 
Background
 
The taxpayers, Shea Homes, Inc. and its subsidiaries, are builders and developers of planned communities in California and throughout the southwest. They develop the land and construct the homes, common improvements and amenities. 
 
Typically a taxpayer must account for income in the taxable year in which it is received. However, there are special rules for reporting taxable income from long-term contracts. A long-term contract is any contract for the manufacture, building, installation, or construction of property, if not completed in the tax year in which it was entered into. Generally, a long-term contract must be accounted for using the percentage completion method pursuant to §460(a).  However, exceptions exist for home construction contracts.
 
Revenue under the completed contract method is recognized when either of two tests is met:
 
  • 95% Completion Test – completion takes place upon use of the property by the customer for its intended purposes and at least 95 percent of the total allocable costs attributable to the subject matter have been incurred by the taxpayer; or
  • Final Completion and Acceptance Test – completion takes place upon final completion and acceptance by the customer, determined by taking into consideration all facts and circumstances. 

 

The taxpayers reported their income using the completed contact method and they applied the 95 percent test to determine the year of contract completion, and, therefore, the year in which they recognized income from the long-term home construction contracts. 
 
IRS’s Argument
 
The IRS argued that income amounts cannot be deferred under the completed contract method of accounting until the completion of a future common improvement because the primary subject matter of the contract was the home and the cost of common improvements and any future obligation are secondary items and do not impact when a contract is completed. For purposes of applying the completed contract method, the subject matter of a contract for sale of a house in a planned community development was limited to the house and lot.  Anything else such as common improvements and amenities constituted secondary items that were to be ignored in determining when the contract was completed. As such, the IRS believed the home construction contracts were complete, under the final completion test, once a home purchase closed in escrow. 
 
Taxpayer’s Argument
 
The taxpayers disagreed with the IRS and countered that the subject matter of the home construction contracts included more than just the house and the lot but included the common improvements and the other requirements needed to create a house within the particularly oriented planned community development that the buyer had bargained for.
 
Tax Court
 
The Tax Court agreed with the taxpayers and ruled in their favor. The Tax Court concluded that the subject matter of the contracts included more than just the houses and lots but included the larger development, common improvements and amenities. The Tax Court found that the amenities of the development were a crucial aspect of the taxpayer’s sales effort, the local government’s decision to approve the development, and the buyer’s decision to purchase houses in the development. Accordingly, the Tax Court ruled because the community amenities were an essential element of the home purchase and sale contract they were properly includable in the determination of whether the requirements for completion had been met. 
 
Ninth Circuit
 
The Ninth Circuit affirmed the Tax Court’s decision and found that the taxpayers used a permissible method of accounting and that method of accounting clearly reflected their income.
 
What Does CohnReznick Think?
 
This case was a significant win for the taxpayer.  Taxpayers that build homes in planned communities should consider the application of this test when analyzing revenue recognition.  
 
Contact
 
For more information, please contact Richard Shevak, Director, National Accounting Methods and Periods Director, at richard.shevak@cohnreznick.com or 862-245-5029.
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