Taxation of Long-term Contracts: Little Pigs, the IRS, and the Completed-Contract Method

Little pigs get fed. Big pigs get slaughtered.

It’s a pithy way of saying that overreaching is dangerous. A recent tax case demonstrates this: The IRS overreached in a real estate developer’s tax case, and it wound up with a ruling it almost certainly regrets.

Income is generally taxable under the Internal Revenue Code in the year that it is received. Long-term contracts are treated differently; most are subject to the percentage of completion method of accounting. Home construction contracts, however, are not.

Little pigs get fed. Big pigs get slaughtered.

One permissible accounting method for home builders is the completed-contract method. Under this method, the key question is when a contract is complete; this can occur upon acceptance by the customer, if at least 95% of the contractual costs have been incurred by the builder or developer.

The Tax Court addressed the completed contract method in a case involving large planned communities ranging from 100 homes to over 1,000. The taxpayers’ business model focused not just on individual homes, but “the features and lifestyle of the community.” Given this focus, the taxpayers treated the subject matter of the contract as the completion of the entire development, which meant they first recognized income from a development in the year when they had incurred at least 95% of their budgeted costs for all of the homes and the associated amenities.

When the taxpayers were audited, the IRS treated each individual house and lot as the subject matter of the contract, resulting in a significant tax deficiency. In the Tax Court, the IRS stuck to this position; in its view, common improvements such as public areas, club houses and other common facilities could be ignored as so-called “secondary items.”

But the amenities that the taxpayers offered were significant; they included clubhouses, ballrooms, locker rooms, pools, cabanas, fitness centers, trail systems, restaurants, tennis courts, open spaces for wildlife, and a country club. While these amenities were plainly part of what the taxpayers’ clients were buying, the government apparently never considered whether there was some reasonable alternative to its position that only the sales of the homes and the lots mattered.

The government’s gambit failed: The Tax Court concluded that the subject of the contract embraced all aspects of the planned community development. On appeal, the government attempted to moderate its position, conceding that the common amenities were relevant in determining whether the contract with a home buyer was complete. The IRS now argued that the Tax Court had improperly considered the budgeted costs for other homes in determining when the contract was complete. While sensible, this more moderate approach ran into an impermeable barrier, the standard of review. The government wanted the Ninth Circuit to treat the Tax Court’s determination of whether the taxpayers’ method of accounting clearly reflected their income as a mixed question of law and fact, subject to de novo review. It refused.

Instead, the Court of Appeals (in the recent Shea Homes v. Comm’r case) concluded that the issue was a factual dispute over the “subject of the contract,” as the government itself had told the Tax Court. Since the Tax Court made a specific factual determination that the subject of the contract embraced the entire development, the court applied the clearly erroneous standard, and it readily concluded that the evidence supported that finding.

Shea Homes provides a template for developers and builders to argue for the deferral of income for a long period of time.

This result leaves the IRS with a serious problem: Shea Homes provides a template for developers and builders to argue for the deferral of income for a long period of time. Even if that position is successfully challenged by the IRS, there appears to be a solid argument that the taxpayer should not be penalized because there is a good faith basis to treat an entire development as the subject matter of a contract under the completed contract method. Developers and builders should nonetheless be careful about overreaching, as each particular case will turn on its facts.

In other words, don’t be a pig.

James R. Malone, Jr. (LL.M. Taxation 2011) is a principal at Post & Schell, P.C., where he concentrates his practice in the representation of taxpayers in federal, state, and local tax controversies.

Leave a Comment