In an action on decision (AOD 2017-03, 2017-15 IRB 1072), the IRS announced that it will not acquiesce to the Ninth Circuit's holding in Shea Homes, Inc. and Subs. v. Commissioner, 834 F.3d 1061 (9th Cir. 2016), aff'g 142 T.C. 60 (2014), that allows the completed contract method of accounting (CCM) to apply to estimated cost of constructing an entire development, rather than an individual home contract. The IRS will follow the decision in cases appealable to the Ninth Circuit, but will continue to litigate in other circuits.

Background

Shea Homes, Inc. (SHI) and its subsidiaries formed an affiliated group of corporations that, through several entities, built and sold homes in master planned community developments ranging in size from 100 to more than 1,000 homes in Colorado, California and Arizona. The total purchase price includes the home, the lot on which the home is constructed, improvements to the lot, infrastructure and amenity common improvements, financing, fees, property taxes, labor and supervision, architectural and environmental design, bonding, or other costs.

SHI entered into individual purchase and sale agreements with all buyers. Before closing escrow on a home, SHI was required to either construct all common improvement areas for the development (or phase) or post a bond securing SHI's performance; the amount of the bond varied by municipality. Typically four to six months lapsed between execution of the purchase agreement and the closing of escrow. SHI accounted for the income from the sale of homes using the CCM, based on completion of the entire development, rather than on the sale of each individual home. The IRS disagreed with this method and determined deficiencies and adjustments. The Tax Court looked at eight representative developments of the 114 total developments from the years at issue. For a full discussion of the Tax Court's ruling, see Tax Alert 2014-328.

On appeal, the IRS changed its approach and conceded that SHI's home construction contracts pertained to more than just individual homes and lots, and included common improvements of each planned community development, improvements that SHI was contractually obligated to build. Instead, the IRS argued that SHI had applied the 95% test incorrectly, asserting that, for purposes of the test, each contract pertained to the particular home and lot, plus the common areas, but not the other homes in the community. Under this approach, the 95% test would be met when SHI incurred 95% "of the budgeted costs of the contracted-for house, lot and common amenities, but not the costs of the other houses."

On August 24, 2016, the Ninth Circuit affirmed the Tax Court's decision that SHI may apply CCM based on completion of the entire development, rather than on the sale of each individual home. Noting that SHI's application of the 95% test clearly reflected income because the purchasers of the homes in the developer's planned communities were contracting to buy more than the "mere 'bricks and sticks' of the homes," agreeing to pay a premium because they expected to have access to the benefits of the development as a whole and to enjoy a certain lifestyle with their neighbors. These expectations were "reflected in, among other things, common improvements, bonding requirements, the creation of homeowners' associations in which each buyer had rights, and in the covenants, conditions and restrictions (CC&R's) that ran with the land and affected not only the buyer but also other prospective buyers and the properties they were purchasing," the appeals court explained. For a full discussion of the Appeals Court's ruling, see Tax Alert 2016-1496.

Action on Decision

The IRS disagrees with the Court's conclusion that the 95% completion test can properly be applied with reference to the costs of an entire development or phase, but rather should apply on a contract-by-contract basis, stating that the total costs of an entire development or phase cannot be the "allocable contract costs" of each individual home construction contract. Further, the definition of contract completion in the regulations assumes that the subject matter of a contract can be used by a customer and that the customer can accept the subject matter. However, in this scenario, the buyer of a house has no right to use other houses in a development and has no authority to accept them.

The IRS stated that, while it disagrees with the decision of the Court, it is precedential for any cases appealable in the Ninth Circuit, and therefore will follow the decision in cases within that circuit, if the opinion cannot be meaningfully distinguished. The IRS will not, however, apply the Tax Court's decision to cases in other circuits and will continue to litigate in other circuits.

Implications

Taxpayers in circuits outside the Ninth Circuit can expect the IRS to raise the issue on audit and to challenge the application of CCM in this favorable manner.

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