Attachment 4 to Industry Director Directive on Super Completed Contract Method
Proforma Form 5701 - Subcontractor Providing Common Improvements Not Allowed CCM
Whether a taxpayer’s contract to perform only off-site improvements for a residential land developer is exempt from the percentage of completion method under section 460 because it meets the definition of a home construction contract.
The taxpayer is a subcontractor hired by a land developer to construct roadways, sidewalks, utilities, grading, or other common improvements within a residential community where single family homes are to be constructed. When entering into the contract, the taxpayer estimated the contract would take more than 2 years after the contract commencement date to complete and the taxpayer’s average annual gross receipts for the prior three years exceeds $10 million.
The taxpayer enters into a single contract for the entire development. The taxpayer treats the long-term construction contract as a home construction contract and as a result has elected the completed contract method of accounting (“CCM”). All income and expenses are being deferred until the contract is completed.
Tax Law & Argument:
I.R.C. §460(a) generally requires the use of the percentage-of- completion method of accounting for long term contracts. See also Treas. Reg. § 1.460-1(a)(1) and Treas. Reg. § 1.460-3(a).
I.R.C. § 460(e)(1)(A) provides an exception from the general rule requiring use of the percentage-of-completion method for "any home construction contract."
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 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.
For purposes of I.R.C. § 460(e)(6)(A), dwelling unit is defined at I.R.C. § 168(e)(2)(A)(ii) as "a house or apartment used to provide living accommodations in a building or structure... ."
Treas. Reg. § 1.460-3(b)(2) further defines a home construction contract:
(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.
Treas. Reg. § 1.460-3(b)(2)(i) describes which long-term construction contracts are home construction contracts. In general, 80% percent of the contract costs must be attributable to the construction of the dwelling unit and improvements to real property “directly related to, and located at the site of, the dwelling units being constructed under the contract in Treas. Reg. 1.460-3(b)(2)(i)(A). For purposes of meeting the 80 percent test, builders with contracts calling for the type of construction described in Treas. Reg. 1.460-3(b)(2)(i) may, under Treas. Reg. 1.460-3(b)(2)(iii), include the dwelling unit’s allocable share of the costs of common improvements (required by law or by the contract) in the cost of the dwelling unit being constructed under the contract. Thus, a contract providing for the construction of a house cannot fail the 80 percent test because the cost of common improvements required by the contract is over 20 percent of the contract costs.
However, a contract solely for the construction of common improvements cannot be a home construction contract for two reasons. First, the contact does not require construction activity described in Treas. Reg. 1.460-3(b)(2)(i). Therefore, the contract will have no dwelling unit cost to which the costs of the common improvements will be added as required by Treas. Reg. 1.460-3(b)(2)(iii). Second, common improvement costs, although added to Treas. Reg. 1.460-3(b)(2)(i) costs, do not qualify by themselves as Treas. Reg. 1.460-3(b)(2)(i) costs. This is because common improvements, regardless of whether they are located on a particular building lot or not, benefit more than one dwelling unit. Therefore, they are not “directly related to” any particular dwelling unit being constructed. In summary, Treas. Reg. 1.460-3(b)(2)(iii) is a cost allocation rule for home construction contracts and does not provide an alternative means to qualify a long-term construction contract as a home construction contract.
The taxpayer’s contract to construct the common improvements does not qualify as a home construction contract; therefore, the taxpayer is not permitted to use the completed contract method of accounting. Per I.R.C. § 460(a), the taxpayer is required to use the percentage-of-completion method.