In Shea Homes, Inc.,No. 14-72161 (9th Cir. 8/24/16), aff'g 142 T.C. 60 (2014), the Ninth Circuit affirmed the Tax Court's decision that a homebuilder in a master planned community development could apply the percentage-of-completion method for income deferred under the completed-contract accounting method, based on completion of the entire development rather than on the sale of each individual home.
Shea Homes Inc. (SHI) and its subsidiaries formed an affiliated group of corporations that, through several entities, built and sold homes in master planned community developments ranging in size from 100 to more than 1,000 homes in Arizona, California, and Colorado. SHI's business model focused on emphasizing the features and lifestyle of the community to potential buyers. The total purchase price included the home, the lot on which the home was constructed, improvements to the lot, infrastructure and amenity common improvements, financing, fees, property taxes, labor and supervision, architectural and environmental design, bonding, and other costs.
SHI entered into individual purchase-and-sale agreements with all buyers. Before closing escrow on a home, SHI was required to either construct all common improvement areas for the development (or phase) or post a bond securing SHI's performance; the amount of the bond varied by municipality. Both the purchase contracts and the closing and escrow instructions included a requirement that the purchasers receive and acknowledge receipt and understanding of the development's public report and the information it contained, which constituted part of the purchase contract. The public report disclosed to a homebuyer the rights and obligations imposed on or granted to the homebuyer as well as the seller with respect to a certain development. Prior to signing the purchase agreement, each buyer also received a copy of the declaration of the covenants, conditions, and restrictions that applied to that particular development. Typically, four to six months lapsed between execution of the purchase agreement and the closing of escrow.
SHI accounted for the income from the sale of homes using the completed-contract method, based on completion of the entire development, rather than on the sale of each individual home. The IRS disagreed with this method and determined deficiencies and adjustments. The Tax Court looked at eight representative developments out of 114 total developments from the years at issue.
Law and Taxpayer and IRS Analyses
Sec. 460(f)(1) defines a long-term contract as "any contract for the manufacture, building, installation, or construction of property if such contract is not completed within the taxable year in which such contract is entered into." Sec. 460(a) generally requires income from any long-term contract to be reported using the percentage-of-completion method.
Sec. 460(e)(1) contains an exception to this general rule and permits the taxpayer to use the completed-contract method in the case of any "home construction contract." Sec. 460(e)(6) defines a home construction contract as:
any construction contract if 80 percent or more of the estimated total contract costs (as of the close of the taxable year in which the contract was entered into) are reasonably expected to be attributable to [construction] activities . . . with respect to:
(i) dwelling units (as defined in section 168(e)(2)(A)(ii)) contained in buildings containing 4 or fewer dwelling units (as so defined), and
(ii) improvements to real property directly related to such dwelling units and located on the site of such dwelling units.
When a taxpayer is permitted to use the completed-contract method, Regs. Sec. 1.460-1(c)(3)(i) imposes two tests to determine when construction is complete: (1) the use and 95% completion test and (2) the final completion and acceptance test. The first test is satisfied when the taxpayer has incurred 95% of the total allocable contract costs. Determining completion is complicated by secondary items. Taxpayers are required to determine and separate the portion of costs attributable to secondary items.
The IRS took the position that the contracts were complete when escrow closed. Under this approach, the "contract" is completed on a house-by-house basis at the close of escrow, and SHI would have to report income from long-term contracts in the years in which the individual home sales contracts closed in escrow. The IRS viewed the subject matter of the contract as the house and lot.
SHI countered that the subject matter of the contract was much broader and included the entire development (or the current phase in a large development). Under this definition, the final completion and acceptance did not occur until the final road was paved and the final bond was released. Regarding the 95% test, SHI contended that the allocable share of the costs of common improvements should be included because they are included in the 80% test for determining whether a contract qualifies as a home construction contract under Sec. 460(e).
The IRS offered an alternative theory that the costs attributable to common improvements are secondary items for purposes of determining the 95% completion test.
Tax Court Decision
The Tax Court reviewed the regulations under Sec. 460 and noted that they explicitly acknowledge that the subject matter of a home construction contract extends beyond the construction of a home. The Tax Court determined that SHI's buyers were consciously purchasing more than the "bricks and sticks" of the home and were paying a premium. The Tax Court pointed to the public report and other documents that buyers received discussing the benefits and conditions of living in the development. A buyer who did not want the amenities of the development would likely buy a comparable house outside the development at a lower price. This was further evidenced by the requirement that SHI purchase performance bonds if all the amenities of a development were not complete when escrow closed. Accordingly, the Tax Court ruled that the execution of the purchase agreement and the closing of escrow did not represent the full subject matter of the contract.
The Tax Court further ruled that the subject matter of the contract included the house, the lot, and improvements to the lot, as well as the common improvements in the development. Thus, for purposes of the 95% completion test, SHI correctly tested the total allocable costs associated with the development against the costs incurred to date. Furthermore, final completion of the contract did not occur until the final bonds were released and the final road paved. Thus, SHI could defer the income from the contracts until 95% of a development was finished.
Referring to the earlier discussion of the contracts, the Tax Court ruled against the IRS's second theory that the costs attributable to common improvements were secondary items. Finally, the Tax Court ruled that the IRS could not change SHI's method of accounting, even if the proposed method more clearly reflected income.
Ninth Circuit Decision
On appeal, the IRS changed its approach and conceded that SHI's home construction contracts pertained to more than just individual homes and lots and included common improvements of each planned community development, improvements that SHI was contractually obligated to build. Instead, the IRS argued that SHI had applied the 95% test incorrectly, asserting that, for purposes of the test, each contract pertained to the particular home and lot plus the common areas but not the other homes in the community. Under this approach, the 95% test would be met when SHI incurred 95% "of the budgeted costs of the contracted-for house, lot and common amenities, but not the costs of the other houses."
In considering "this late-blooming argument," the appeals court examined the "two somewhat separate questions involved in accounting cases: Did a taxpayer's method of accounting clearly reflect income and, if not, did the Commissioner choose a method that did?" SHI asserted, and the IRS did not reject, that a taxpayer can win in the Tax Court by showing either that its accounting method clearly reflected income or that the IRS's method did not. The appeals court rejected the IRS's assertion that SHI's accounting method did not clearly reflect income and that the court should review it as a mixed question of fact and law. In the lower court, the IRS argued that the issue was a "question of fact to be determined on a case-by-case basis."
The Ninth Circuit reviewed the Tax Court's factual determinations for clear error, reversible only if the appeals court had "a 'definite and firm conviction' that the [Tax Court's] factual finding was wrong" (quoting Meruelo, 691 F.3d 1114 (9th Cir. 2012)), and found sufficient evidence to support the Tax Court's factual determinations.
SHI's application of the 95% test clearly reflected income because the purchasers of the homes in the developer's planned communities were contracting to buy more than the "mere 'bricks and sticks' of the homes," agreeing to pay a premium because they expected to have access to the benefits of the development as a whole and to enjoy a certain lifestyle with their neighbors. These expectations were "reflected in, among other things, common improvements, bonding requirements, the creation of homeowners' associations in which each buyer had rights, and in the covenants, conditions and restrictions . . . that ran with the land and affected not only the buyer but also other prospective buyers and the properties they were purchasing," the appeals court explained.
In its discussion, the appeals court stated that:
The Commissioner complains that the Tax Court focused on the house, lot and common amenities in its opinion. The Commissioner then suggests that when the Tax Court mentioned the development as a whole, it was, somehow, being inconsistent. The Commissioner overlooks the fact that his focus was on those specific aspects, and those are what he specifically pointed to when he was stating his position for purposes of the trial of this case at the Tax Court. We suspect that the Commissioner was satisfied that his position on those points would win the day and, therefore, that he need not concentrate his firepower on the overall planned community development aspect of the contracts. The resulting outcome was due to his misperception rather than a Tax Court mistake.
In closing, the Appeals Court emphasized this caution offered by the Tax Court:
We are cognizant that our Opinion today could lead taxpayers to believe that large developments may qualify for extremely long, almost unlimited deferral periods. We would caution those taxpayers a determination of the subject matter of the contract is based on all the facts and circumstances.
In a concurring opinion, Justice Johnnie Rawlinson of the Ninth Circuit indicated that she would affirm the Tax Court's decision solely on procedural grounds since the IRS's argument on appeal "was not raised sufficiently for the Tax Court to rule on it," and appellate review should be limited to issues raised at trial.
The Ninth Circuit's decision in Shea Homes is a clear win for homebuilders that currently recognize or hope to recognize income from the sale of completed homes under the completed-contract method based on completion of the entire development rather than on the sale of each individual home. Other taxpayers hoping to rely on this decision, however, should evaluate a number of considerations before electing this application of the completed-contract method, including the Ninth Circuit's refusal to address the argument advanced by the IRS on appeal.
Although the IRS lost this case, the Fifth Circuit issued an IRS-friendly decision in The Howard Hughes Co., L.L.C., 805 F.3d 175 (5th Cir. 2015). In Howard Hughes, the Fifth Circuit upheld a Tax Court decision that a residential land developer's bulk sale and custom lot contracts constituted long-term construction contracts but were not home construction contracts within the meaning of Sec. 460(e), so the developer could not report gain and loss from these contracts using the completed-contract method. While both cases involve the use and application of the completed-contract method, it is important to highlight two key differences between the two taxpayers in question:
- The taxpayer in Howard Hughes was not a homebuilder but rather a land developer that sold finished lots to builders, which then built homes for sale to homebuyers.
- The deferral resulting from the use of the completed-contract method by the taxpayer in Shea Homes was less than five years on average. The deferral period in Howard Hughes, in some instances, was substantially longer.
Finally, Treasury and the IRS have included as part of the 2016—2017 Priority Guidance Plan issuing regulations under Sec. 460 to address home construction contracts and rules for certain changes in methods of accounting for long-term contracts. It is possible that Treasury and the IRS may use the decisions in Shea Homes and Howard Hughes in drafting those regulations to curtail any perceived taxpayer abuse.
Michael Dell is a partner at Ernst & Young LLP in Washington.
For additional information about these items, contact Mr. Dell at 202-327-8788 or email@example.com.
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