The Internal Revenue Service (“IRS”) announced the rollout of 13 examination “campaigns” administered by the IRS’s Large Business and International Division. One such campaign addresses home builders’ and land developers’ use of the Completed Contract Method of Accounting (the “CCM”).
The CCM Generally
Code section 460 and regulations thereunder permit the use of the CCM for two types of long-term contracts, one of which is long-term home construction contracts. A long-term contract is one that is not completed in the same taxable year that it is entered into. I.R.C. § 460(f)(1). Large home builders eligible for the CCM for long-term home construction contracts may defer the recognition of revenue and costs associated with those contracts until the contracts are complete.
The regulations provide that a home construction contract is complete at the earlier of one of two tests—the 95% completion test, and the final completion and acceptance test. Under the first of these tests, the contract is complete upon “[u]se of the subject matter of the contract by the customer for its intended purpose (other than for testing) and at least 95 percent of the total allocable contract costs attributable to the subject matter have been incurred by the taxpayer.” Treas. Reg. § 1.460-1(c)(3)(i)(A). Alternatively, under the second test, a contract is complete upon “[f]inal completion and acceptance of the subject matter of the contract.” Treas. Reg. § 1.460-1(c)(3)(i)(B). Moreover, in applying these tests, a taxpayer is to determine whether a contract is complete “without regard to whether one or more secondary items have been used or finally completed and accepted.” Treas. Reg. § 1.460-1(c)(3)(ii).
Under these rules, home and land developers utilizing the CCM have sought to defer the recognition of profits on the sale of their homes for several years, and in some instances until an entire development has been completed.
The IRS, in challenging home and land developers’ use of the CCM, has historically taken four alternative positions:
1. The contract at issue is not a home construction contract because the item being sold is not a home, but only a piece of land. This position is asserted against land developers who prepare land for homes to be built, but do not build and sell the homes themselves.
2. When a developer does build a home, the subject matter of a home construction contract is limited to the home itself and the lot on which it sits, and so does not include “common improvements” (e.g., roads, sewers, club houses, nature trails, pools, etc.). Under this position, the IRS asserts that a home construction contract is complete, and income is recognized, as soon as escrow on a home closes.
3. Even if the subject matter includes common improvements, those elements are “secondary items,” and therefore not considered for purposes of determining contract completion. Under this position, the IRS asserts that a home construction contract is complete as soon as escrow closes, but that the recognition of revenue and costs attributable to common improvements may, in certain circumstances, be deferred until those items are finished.
4. Even if common improvements are part of the subject matter and are not secondary items, the balance of the development (i.e., the other homes) is not part of the subject matter of the home construction contract. Under this position, the IRS asserts that a home construction contract is complete, and income must be recognized, when 95 percent of the costs attributable to the home, lot, and allocable common improvements are incurred.
The IRS’s CCM Campaign
In its announcement, the IRS identifies the application of the CCM to land and home developers as one of its areas of upcoming examination focus. Specifically, the IRS states that:
Large land developers that construct in residential communities may be improperly using the Completed Contract Method (CCM) of accounting. A developer, whose average annual gross receipts exceed $10 million, may only use the CCM under a home construction contract. In some cases, developers are improperly deferring all gain until the entire development is completed.
The IRS appears to be focusing its examination efforts on the fourth alternative described above. Namely, by describing the deferral of “all gain until the entire development is completed” as inappropriate, the IRS makes clear that it rejects the position that a home construction contract includes all elements of a development, including the other homes. Additionally, the IRS appears to be asserting that only contracts related to the sale of a home qualify as a home construction contract, advancing the first alternative set forth above.
The IRS’s announcement also states that the IRS “will provide training for revenue agents assigned to work this issue. The treatment stream includes development of a practice unit, issuance of soft letters, and follow-up with issue based examinations when warranted.” Accordingly, home and land developers can expect a broad-based approach to this issue from the IRS, including targeted examinations focused on the application of the CCM. Similarly, home and land developers filing changes in method of accounting and/or refund claims should anticipate a focused review by the IRS.
Successful Challenge to Service’s Position
To date, only one taxpayer has successfully challenged the Service’s position on the CCM in court. In Shea Homes, Inc. v. Commissioner, the Tax Court ruled that, when supported by the facts, a home construction contract’s subject matter includes the home, the lot on which it sits, common improvements, and the other homes in the development. Put differently, the Tax Court recognized that “the subject matter of [the Taxpayers’] contracts includes the development” as a whole. 142 T.C. 60, 109 n.23 (2014). Accordingly, the Tax Court permitted Shea Homes to use the CCM to defer the recognition of income from home sales until the entire development was nearly complete. This decision was affirmed by the Ninth Circuit, which recognized that “[e]ach person in the planned community would, indeed, have an interest in the use of other property in the development, and that would include not only the common amenities but also the use that others in the development made of their own properties.” 118 AFTR 2d 5593, 5598 (9th Cir. 2016).
Home and land developers must be wary of the IRS’s new campaign. The Ninth Circuit made clear that despite Shea Homes’ win, we would be remiss if we did not close this opinion with the Tax Court’s admonition: ‘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.118 AFTR 2d 5593, 5599 (9th Cir. 2016). Accordingly, the IRS’s announcement of its new campaign against home and land developers should not be taken lightly. The facts of each case, the way the law applies in light of those facts, and the way the facts are presented to the IRS and/or in litigation, will be exceptionally important.
Notwithstanding the foregoing, home developers who construct residential developments that do not currently use the CCM to account for their revenues and costs may want to consider changing their method of accounting, in order to take advantage of the Shea Homes decision in the Tax Court and Ninth Circuit. For some taxpayers, doing so could also yield a claim for refund of taxes previously paid.