Industry Director Directive on Super Completed Contract Method
DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224
Impacted IRM 4.51.5
Large and Mid-Size Business Division
MEMORANDUM FOR INDUSTRY DIRECTORS
DIRECTOR, FIELD SPECIALISTS
DIRECTOR, PREFILING AND TECHNICAL GUIDANCE
DIRECTOR, INTERNATIONAL COMPLIANCE STRATEGY AND POLICY
FROM: Keith M. Jones
Natural Resources and Construction
SUBJECT: Super Completed Contract Method
This memorandum provides field direction on the Super Completed Contract Method Issue.
The completed contract method of accounting is generally the preferred tax method used in the construction industry since it allows the taxpayer to defer the recognition of income & expenses until the contract is complete. The misuse of the completed contract method is a growing trend within the construction industry as follows:
Taxpayers are improperly using the Completed Contract Method (CCM) – under circumstances where it is not an allowable method (Scenario 1 & 2)
Taxpayers are improperly deferring completion under CCM (Scenario 2, 3 & 4)
The scenarios below give examples of the improper treatment:
A land developer (taxpayer) enters into a sales/construction contract to provide improved lots. The taxpayer sells the lot and is contractually obligated to provide a future common improvement (i.e. clubhouse, pool, roads, etc.). The taxpayer treats the contract as a home construction contract and defers income recognition until the future common improvement is completed.
The taxpayer is a subcontractor hired by the land developer to construct roadways, sidewalks, utilities, grading, or other common improvements within a residential community. The taxpayer treats the contract as a home construction contract, thus deferring the progress payments until the entire contract is completed.
Taxpayer sets up two partnerships to separate land development from home construction. The land developer enters into one contract for the homebuilder to build all the homes in the development. The homebuilder defers the income on homes it builds until the entire contract is completed. The land developer may be deferring the lot sales the same as item 1.
Homebuilder "adopts" the project-by-project basis provided in Rev. Proc. 92-29 to determine when completion occurs. None of the home sales are recognized until the entire development (project) is done.
The land developer/homebuilder is required to provide a future common improvement to a development. As the homes are sold, the developer/homebuilder's position is that the home is not 95% complete because the allocable portion of the future common improvement keeps the completion factor for that particular home less than 95%.
There is currently an IIR team working to clarify the definition of a “home construction contract”, which will address the first two scenarios above.
UIL Code: 460.04-00 Exception for Certain Construction Contracts
460.04-01 Home Construction Contract Exceptions
SAIN: 707 Accounting Methods
Second Tier SAIN: 360 Completed Contract Method
Project Code: 0539
ERCS Tracking Code: 0539
Planning and Examination Guidance:
This issue can be identified as follows:
Schedule M-3, Part II, Line 21 Temporary book to tax income difference of $10M or greater with NAICS codes 236100, 237210, 233110, 233200, 233210, 236115, 236117, and 236000.
Schedule M-3, Part II, Line 26 Temporary book to tax difference of $10M or greater with NAICS codes 236100, 237210, 233110, 233200, 233210, 236115, 236117, and 236000.
Form 8886, Reportable Transaction Disclosure Statement, Line 2(e) checked indicating a book/tax difference of $10M or greater. The description of the book/tax difference would identify the taxpayer as being in the land development, real estate sales, or home construction industry. For tax years 2006 and later, this form is no longer required for book/tax differences of $10M or greater.
Annual Report of the company or SEC 10-K may identify a deferred tax liability associated with the completed contract method of accounting.
Compliance initiative project has been approved, and returns will be sent out to teams to be assigned as part of this project.
Planning and Examination Risk Analysis
If this issue is identified during initial planning and risk analysis, the agent should contact Jeanne Wierman, Construction TA to discuss the issue. If the issue is examined, the agent needs to contact Steven Powell, SCCM CIP Coordinator, to provide specific information regarding the case by sending an e-mail to Steven.G.Powell@irs.gov.
Large master planned communities take many years to complete. Taxpayers are deferring income from the sale of the homes many years into the future (5, 10, 15 years or more). Therefore, the subsequent sale of one of these homes could be a taxable transaction long before the builder recognized income from the initial sale of the home. This is an obvious abuse of the tax law. Therefore, this is a mandatory audit issue which will ensure consistency and to prevent widespread use of an improper method.
During the initial stages of the examination, the examiner should determine the fact pattern of the issue and obtain the contracts between the land developer and home builder, home builder and home buyer, and any other contracts which provide the contractual obligations for common improvements that are to be provided.
The examiner will also need to obtain the listing of all homes that have been sold to date to determine the examination adjustment. This should reconcile to the book/tax difference listed on the tax return, but the examiner should have supporting documentation to verify the amount.
The examiner should ascertain whether a change in method of accounting was required if the taxpayer adopted this method after the first year.
Proforma Information Document Request (IDR) and Form 5701s are as follows:
Attachment 1 - Proforma IDR for deferral of home sales until 95% of costs are incurred
Attachment 2 - Proforma Form 5701 for homebuilder deferring sale of home and/or lots until 95% completion
Attachment 3 - Proforma IDR for subcontractor only providing common improvements within a residential community
Attachment 4 - Proforma Form 5701 for subcontractor only providing common improvements within a residential community
Attachment 5 - Proforma Form 5701 for land developer deferring sales of improved lots under the completed contract method until the entire development is considered complete.
An IIR team is currently working on the definition of a “home construction contract” which will determine whether a land developer’s sales/construction contracts meet the criteria. However, for the other three scenarios listed above (the taxpayer’s contracts meet the definition of a home construction contract) the issue then becomes when the contract is considered complete for income tax recognition.
The current LMSB position is that as each home is sold, the contract is considered complete, and income is recognized. Depending on the scenario, the severance rules under IRC 460 would be applied segregating each individual home into a contract, (the project-by-project method is an improper aggregation of individual contracts) or the subject matter vs. secondary items would be addressed.
In the cases we have seen so far, the taxpayer’s position is egregious and depending upon the materiality of the issue, penalties should be considered and applied.
Effect on Other Guidance:
This Directive is not an official pronouncement of law, and cannot be used, cited, or relied upon as such.
If you need assistance please contact:
LMSB Construction Technical Advisor
1 Poston Road Suite 220
Charleston, SC 29407
CC: Commissioner, LMSB
Deputy Commissioner, Operations
Deputy Commissioner, International
Division Counsel, LMSB
Directors, Field Operations
Director, Performance, Quality and Audit Assistance