Attachment 2 to Industry Director Directive on Super Completed Contract Method
Proforma Form 5701 – Homebuilder Deferring Sale of Home and/or Lot Until 95% Completion
Whether a taxpayer can defer the income from the sale of a constructed home because he includes the allocable costs of common improvements in the 95% completion computation under Treas. Reg. § 1.460-1(c)(3)(A)?
The taxpayer bought a tract of land with the intent to subdivide the property and construct single family homes. The taxpayer enters into a long-term construction contract to build a particular home for a buyer. The taxpayer has properly elected the completed-contract method for its exempt long-term construction contracts. The taxpayer is also contractually obligated to provide common improvements within the tract of land where the homes are to be constructed. At the time of closing, when title of the home is transferred to the buyer, the taxpayer receives the full contract price. However, not all common improvements have been constructed by the taxpayer.
An example of the cost allocation of a particular home, at the time of sale, is shown below:
Allocable Contract Cost Incurred on the lot (underlying land) $ 50,000
Allocable Contract Cost Incurred on the construction of the home 300,000
Allocable Contract Cost Incurred on common improvements 20,000
Allocable Contract Cost to be incurred on common improvements 30,000
Total Estimated Contract Cost $400,000
At the time of sale of the home, $370,000 of the allocable contract costs have been incurred, which is 92.5% of the total estimated allocable cost of the contract. The taxpayer asserts that the above computation allows the taxpayer to defer income from the sale of the home until the 95% threshold for completion is met per Treas. Reg. § 1.460-1(c)(3)(A).
Tax Law & Argument:
I.R.C. §460(a) generally requires the use of the percentage-of-completion method of accounting for long-term contracts. I.R.C. § 460(e)(1)(A) provides exceptions from the general rule requiring use of the percentage-of-completion method, including one applicable here, for “any home construction contract." I.R.C. § 1.460-4(c)(1) provides permissible exempt construction contract methods such as the completed-contract method (“CCM”) used by the taxpayer herein. Treas. Reg. § 1.460-4(d)(1) states, in general, that “a taxpayer using the CCM to account for a long-term contract must take into account in the contract’s completion year, as defined in § 1.460-1(b)(6), the gross contract price and all allocable contract costs incurred by the completion year.”
Treas. Reg. § 1.460-1(b)(6) defines “completion year” as “the taxable year in which a taxpayer completes a contract as described in paragraph (c)(3) of section.” Treas. Reg. § 1.460-1(c)(3) defines contract completion:
(i) In general. —A taxpayer's contract is completed upon the earlier of —
(A) Use 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; or
(B) Final completion and acceptance of the subject matter of the contract.
(ii) Secondary items. —The date a contract accounted for using the CCM is completed is determined without regard to whether one or more secondary items have been used or finally completed and accepted. If any secondary items are incomplete at the end of the taxable year in which the primary subject matter of a contract is completed, the taxpayer must separate the portion of the gross contract price and the allocable contract costs attributable to the incomplete secondary item(s) from the completed contract and account for them using a permissible method of accounting. A permissible method of accounting includes a long-term contract method of accounting only if a separate contract for the secondary item(s) would be a long-term contract, as defined in paragraph (b)(1) of this section.
In other words, the contract is completed the earlier of (1) when the taxpayer incurs 95% of the costs of the subject matter and the customer uses the subject matter as intended, or (2) the taxpayer completes the subject matter and the customer accepts it. The question is whether the “subject matter” includes common improvements.
When issuing the current regulations, the Treasury Department intended that the test for contract completeness reflect the substance of the transaction and discourage the use of formalities that would unreasonably delay a contract’s completion. See “Accounting for Long-Term Contracts,” 66 Fed. Reg. 2219, 2220 (Jan. 11, 2001).
Accordingly, Treas. Reg. § 1.460-1(c)(3)(ii) plainly states that the taxpayer must separate secondary items that are incomplete “at the end of the taxable year in which the primary subject matter of the contract is completed . . ..” Under our facts, the “primary subject matter” of the contract is the home which the taxpayer completed. The sale closed, and title was delivered to the buyer, with the taxpayer receiving the full contract price by the end of the taxable year. The contract is for the sale and construction of a home. Any common improvements that the taxpayer is contractually obligated to provide are neither separately priced in the contract nor are they subject to a separate acceptance by the customer, which further supports the position that the construction of the home is the primary subject matter of the contract. Collectively, the common improvements benefit all the parcels in the tract of land and not just this one parcel or home. The subject matter of the contract is the construction of a home.
The final question is whether at least 95% of the costs “attributable to the subject matter” have been incurred by the taxpayer. Since the subject matter is the construction of the home, the taxpayer must omit the allocable costs of common improvements from this computation because they are not the primary subject matter of the contract under Treas. Reg. § 1.460-1(c)(3)(ii). Consequently, the taxpayer has incurred more than 95% of the costs and, together with the customer’s use of the house for its intended purpose, has satisfied the first test for contract completion under Treas. Reg. § 1.460-1(c)(3)(i)(A). This reflects the substance of the transaction and discourages the abuse of income deferral which the Treasury Department intended under the regulation.
Further, the contract is complete because final completion and acceptance of the subject matter of the contract has occurred, meeting the second alternative test of Treas. Reg. § 1.460-1(c)(3)(i). The full contract price paid for the home is received by the taxpayer upon the closing of the home. Also, title passes and the customer has use of the home for its intended purpose: the home can be used as a dwelling unit, which satisfies part of the first alternative test in the regulation. The use of the home is neither dependent upon nor impaired by the uncompleted common improvements (e.g. pool, clubhouse, etc.), which must be considered secondary items.
The taxpayer argues that these authorities support the position that the common improvements are part of the subject matter of the contract: (1) Example 4 of Treas. Reg. § 1.460-1(j); (2) Ball, Ball and Brosamer, Inc. v. Commissioner, 964 F.2d 890 (9th Cir. 1992), aff’g T.C. Memo. 1990-454; and (3) the definition of a home construction contract in Treas. Reg. § 1.460-3(b)(2)(iii).
In Example 4 of Treas. Reg. § 1.460-1(j), the taxpayer agreed to construct a shopping center with an adjoining parking lot. By the end of the taxable year in issue, the customer began using the retail portion of the shopping center, but not a portion of the parking lot because it was not finished. Allocable contract costs for the unfinished portion exceeded 5% of “total allocable contract costs attributable to the subject matter.” The parking lot is not a common improvement. The use of the retail shopping center is dependent upon the use of a parking lot by its customers. Without ample parking, the taxpayer’s customer is unable to attract the capacity of business that the retail shopping center can accommodate. This example would more appropriately parallel a home with an unfinished driveway when the customer moves in. Under a construction contract, the contractor’s failure to perform its obligation would prevent the customer from using the subject matter for its intended purpose. The extension of example 4 to common improvements that may be located blocks, even miles away, is without merit.
The taxpayer also argues for the application of Ball, Ball and Brosamer, Inc., where the court applied a facts and circumstances analysis under the now obsolete Treas. Reg. § 1.451-3(b)(2) to conclude that minor unfinished work precluded final completion and acceptance of the contract. Prior to the issuance of the current regulations under § 460, final completion and acceptance was the only test for contract completion, determined by facts and circumstances. (See the now-obsolete Treas. Reg. § 1.451-3(b)(2)). For contracts entered into after January 10, 2001, the new regulations define completion by providing a test that explicitly differs from that applied in Ball, Ball, and Brosamer, Inc. A contract is now deemed complete the earlier of when the customer uses the subject matter of that contract and the taxpayer has incurred at least 95% of the total allocable costs attributable to the subject matter, or the taxpayer has completed the subject matter and the customer has accepted it. Further, the subject matter in either test is the primary subject matter, the home. See Treas. Reg. § 1.460-1(c)(3). Without agreeing with how the court in Ball, Ball and Brosamer, Inc applied the final completion and acceptance test, the Treasury Department issued the new alternative test for contract completeness in order to ensure that the completion date comports with the substance of the transaction. See “Accounting for Long-Term Contracts,” 66 Fed. Reg. 2219, 2220 (Jan. 11, 2001).
Finally, the taxpayer cannot rely on the definition of a home construction contract in Treas. Reg. § 1.460-3(b)(2)(iii) for the inclusion of common improvements in the cost of the dwelling units for purposes of contract completion. I.R.C. § 460(e)(6)(A) defines a home construction contract:
460(e)(6)(A) HOME CONSTRUCTION CONTRACT. —The term “home construction contract” means 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 activities referred to in paragraph (4) with respect to —
460(e)(6)(A)(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
460(e)(6)(A)(ii) improvements to real property directly related to such dwelling units and located on the site of such dwelling units.
For purposes of clause (i), each townhouse or rowhouse shall be treated as a separate building.
Treas. Reg. § 1.460-3(b)(2) further defines a home construction contract, by including “common improvements”:
(2) Home construction contract
(i) In general. —A long-term construction contract is a home construction contract if a taxpayer (including a subcontractor working for a general contractor) reasonably expects to attribute 80 percent or more of the estimated total allocable contract costs (including the cost of land, materials, and services), determined as of the close of the contracting year, to the construction of —
(A) Dwelling units, as defined in section 168(e)(2)(A)(ii)(I), contained in buildings containing 4 or fewer dwelling units (including buildings with 4 or fewer dwelling units that also have commercial units); and
(B) Improvements to real property directly related to, and located at the site of, the dwelling units.
(ii) Townhouses and rowhouses. —Each townhouse or rowhouse is a separate building.
(iii) Common improvements. —A taxpayer includes in the cost of the dwelling units their allocable share of the cost that the taxpayer reasonably expects to incur for any common improvements (e.g., sewers, roads, clubhouses) that benefit the dwelling units and that the taxpayer is contractually obligated, or required by law, to construct within the tract or tracts of land that contain the dwelling units.
Under this regulation, inclusion of common improvements in the cost of the dwelling units qualifies many homebuilding contracts as “home construction” contracts when the cost of the common improvements exceeds 20% of the allocable contract costs. Thus, these homebuilders may use the completed-contract method for large, master planned communities that provide extensive common improvements, such as golf courses, pools, tennis courts, and schools.
Whether or not the taxpayer has a home construction contract is not at issue. The Service agrees that the taxpayer’s contract meets the definition of a home construction contract; therefore, the completed contract method is a proper method for its long-term construction contracts. The issue is when the contract is considered complete for tax reporting purposes. While the “common improvements” subparagraph in Treas. Reg. § 1.460-3(b)(2), above, adds to the definition for a “home construction contract,” Treas. Reg. § 1.460-1(c)(3), on the other hand, implicitly excludes common improvements from the definition for “contract completion.” The latter regulation specifies that only allocable costs “attributable to the subject matter” of the contract are includible in the 95% computation towards contract completion, and, as previously discussed, the regulation explicitly provides that only the primary subject matter be considered in the determination of the completion date. Construction of the home is the primary subject matter of the contract, not common improvements. The common improvement computation in determining the question of a home construction contract in Treas. Reg. § 1.460-3(b)(2)(iii) does not apply when determining contract completion.
Under these facts, the taxpayer cannot defer the completion of the contract until the completion of a future common improvement. The contract is completed in the year in which either (1) 95% of the total allocable contract costs of the primary subject matter of the contract, the home, have been incurred, and the home is being used by the customer for its intended purpose, or (2) the home is completed and accepted by the customer, whichever of these two tests is met first.