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Ninth Circuit Affirms Home Builder's Use of Completed Contract Method for Planned Community

(Parker Tax Publishing September 2016)

The Ninth Circuit affirmed the Tax Court and held that a homebuilder and its affiliates properly accounted for income from their home construction contracts under the completed contract method of accounting. In doing so, the court rejected the IRS's contention that the subject matter of the contracts at issue was limited to a buyer's purchase of a house and lot, concluding instead that the subject matter of the contracts also included the development and its common improvements and amenities. As a result, the taxpayer was able to defer taxes on home sales in a planned community until 95 percent of the community was completed and accepted. Shea Homes, Inc. and Subsidiaries v. Comm'r, 2016 PTC 323 (9th Cir. 2016).


Shea Homes, Inc. and Subsidiaries (SHI), is an affiliated group of corporations and a builder and developer of planned communities ranging in size from 100 homes to more than 1,000 homes in Colorado, California, and Arizona. SHI prides itself on providing customers with more than just the "bricks and sticks" of a home and emphasizes the features and lifestyle of a community to potential buyers.

SHI purchases land in various stages, from completely raw to finished lots in developed communities. Its business involves the analysis and acquisition of land for development, the construction and marketing of homes, and the design and/or construction of developments and homes on the land acquired. The costs incurred in its home construction business include: (1) acquisition of land; (2) financing; (3) municipal and other regulatory approvals of entitlements; (4) construction of infrastructure; (5) construction of amenities; (6) construction of homes; (7) marketing; (8) bonding; (9) site supervision and overhead; and (10) taxes. SHI's primary source of revenue from the home development business is from the sale of houses, a process that tends to take place over more than one tax year. SHI treats its home sale contracts as long-term home construction contracts and reports income using the completed contract method (CCM). Under Reg. Sec. 1.460-1(c)(3)(i), a taxpayer's contract is completed upon the earlier of:

(1) use of the subject matter of the contract by the customer for its intended purpose and at least 95 percent of the total allocable contract costs attributable to the subject matter have been incurred by the taxpayer; or

(2) final completion and acceptance of the subject matter of the contract.

In addition, Reg. Sec. 1.460-1(c)(3)(ii) provides that the date of contract completion is determined without regard to whether one or more secondary items have been used or finally completed and accepted.

SHI constructs its developments in a sequence of stages consisting of: (1) grading land; (2) initial construction of amenity and infrastructure common improvements; (3) construction of homes; and (4) construction and finalization of any remaining common improvements. The amount of time it takes to grade the land and initially construct the amenities and common infrastructure vary with the size, surface and subsurface condition, and nature of the development. SHI charges a single price for its homes. Before closing on a home, SHI must either construct all common improvement areas for the development (or phase) or post a bond. Therefore, in some instances the buyers pay the full contract price before all of the common improvements and amenities promised for that development are completed.

In reporting its taxable income, SHI applies the 95 percent test to determine the year of contract completion and, hence, the year in which it recognizes income from the long-term home construction contracts.

For the years at issue, SHI took the position that the subject matter of the home construction contracts included the development in which the home was situated. For each tax year, SHI would calculate, on a development-by-development basis, whether it had incurred at least 95 percent of the budgeted costs of the development, including the costs of the houses and the common improvements and amenities. If the incurred costs were equal to or greater than 95 percent of the budgeted costs, then SHI 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 percent, then SHI deferred any income from homes that closed in escrow that year.

Shea Homes and IRS Positions

The IRS disagreed with SHI's tax treatment of its home sale contracts and assessed tax deficiencies. According to the IRS, SHI and its affiliates could not defer amounts under the CCM 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 obligations were secondary items and did not impact when a contract was completed on the subject matter. In effect, the IRS's position was that the subject matter of a contract for a home sale in a planned community development was limited to the house and lot alone. Citing Reg. Sec. 1.460-1(c)(3)(ii), the IRS said that anything other than the house and lot - for example, the common improvements - constituted "secondary items" to be ignored in determining when the contract was completed. In the IRS's view, SHI's home construction contracts were complete, under the final completion test, once a home purchase closed in escrow, even if SHI had not yet finished the development or the common improvements and amenities to which the buyer was entitled pursuant to his sale contract with SHI.

SHI argued that the subject matter of its contracts with the buyers went beyond a mere house and lot sale because it 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. Therefore, SHI said, it had properly applied the 95 percent test to determine the date of contract completion, and its method of accounting reflected the subject matter of its home construction contracts and clearly reflected income. SHI argued that the IRS's proposed method of recognizing income upon closing of a home purchase in escrow did not clearly reflect income.

Tax Court Sides with Shea Homes

The Tax Court agreed with SHI and held that the subject matter of the contracts consisted of the home and the larger development, including amenities and other common improvements. The court concluded that SHI and its affiliates properly reported income and losses from sales of homes in their planned developments using their interpretation of the CCM. According to the Tax Court, all aspects of the planned community development were understood by SHI and its buyers to be what was bargained for, and the home sale contracts reflected that understanding. SHI and its buyers had contracted for the entire lifestyle of the development and its amenities, the court noted, and the subject matter of each individually purchased home included the development, or phase of development, and its common improvements and amenities. The IRS appealed to the Ninth Circuit.

Arguments on Appeal

Before the Ninth Circuit, the IRS argued that SHI had to report income from its long-term contracts for the years in which the contracts closed in escrow because, in the IRS's view, the subject matter of the contract is the home and the lot upon which it sits. For other contracts, the IRS contended, SHI must account for the income under their normal method of accounting.

Alternatively, the IRS argued that if the Ninth Circuit held that the subject matter of the contracts was broader than the house and the lot, the court should apply the 95 percent completion test without regard to the costs attributable to common improvements because such improvements are secondary items. SHI rejected that analysis, contending that the common improvements are part of the primary subject matter of the contract - not secondary items - and that it could include such allocable costs in applying the 95 percent test.

Ninth Circuit's Rejects IRS Theories

The Ninth Circuit affirmed the Tax Court's decision. The contractual documents at issue, the court concluded, consisted of more than just the purchase and sale agreement. When such documents are examined together, the court said, it becomes readily apparent that the primary subject matter of the contracts includes the house, the lot, improvements to the lot, and common improvements to the development. The court found the amenities to be of great importance to, and a crucial aspect of, SHI's sales effort and thus an essential element of the home purchase and sale contract.

With respect to the IRS's alternative argument regarding the cost of the improvements being treated as secondary items, the court noted that the regulations do not define the term "secondary items." However, the court said, it was clear that the primary subject matter of the contracts included the improvements to the lot as well as the common improvements to the development and thus the improvements were an essential element of the home purchase and sale contract. The court noted that the appropriate scope of each contract as it involved common or exclusive off-lot amenities was a factual question and the IRS did not show that SHI's choices of development or phase as the scope for purposes of the 95 percent test as it involved off-lot amenities were improper or unreasonable.

Finally, the Ninth Circuit said that it was cognizant that its opinion could lead some taxpayers to believe that large developments might qualify for extremely long, almost unlimited deferral periods. It cautioned that a determination of the subject matter of the contract is based on all the facts and circumstances and that if one of the SHI's affiliates had, for example, attempted to apply the contract completion tests by looking at all contemplated phases, it was unlikely that the subject matter as contemplated by the contracting parties could be stretched that far. Additionally, the court noted, Reg. Sec. 1.460-1(c)(3)(iv)(A) (relating to final completion and acceptance) may prohibit taxpayers from inserting language in their contracts that would unreasonably delay completion until such a super development is completed.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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