In the case of Shea Homes, Inc. v. Commissioner, 142 TC No.3, the question of the scope of contracts of a homebuilder when making use of the completed contract method was the key issue. And the IRS did not like the answer that either the Tax Court or the Ninth Circuit Court of Appeals gave, eventually releasing Action on Decision 2017-03 announcing the agency will not acquiesce in the decision, following it only on cases appealable to the Ninth Circuit that cannot be distinguished.
The taxpayer developed large planned residential communities which had substantial common area developments and improvements required by the localities in which the developments were located.
While most long-term contracts must be accounted for using the percentage of completion method [IRC §460(a)]. However, a special exception exists for home construction contracts [IRC§460(e)(1)(A), (6)(A)]. A home construction contract is one in which 80% or more of the estimated total contract costs are expected to be attributable to dwelling units and improvements to real property directly related to such units.
Under the completed contract method, revenue from the contract is recognized when either of two “completion” tests are met [Reg. §1.460‑1(f)]:
- Use and 95% Completion Test – completion takes place upon use of the property by the customer for its intended purpose and at least 95% of the total allocable costs attributable to the subject matter have been incurred by the taxpayer; or
- Final Completion and Acceptance Test – completion takes place upon final completion and acceptance by the customer, determined by taking into account all facts and circumstances.
The dispute arose over what consideration, if any, should be given to costs related to development wide expenses (common areas, road improvements, etc.) and their state of completion when making the determination under either of the above tests.
The IRS argued that when a customer closes on the home after the construction of their structure is completed that both tests are met, and the entire contract price for that home should be recognized by the taxpayer. In the IRS view, both tests would be met at this point—100% of the costs would be incurred and there would be both final completion and acceptance. The common area items are “secondary items” which, under Reg. §1.460‑1(c)(3)(ii), are not to be considered in determining the completed status of the contract.
The taxpayer (and, it turns out, the Tax Court) disagreed with that view. The taxpayer pointed out that substantial costs were being incurred with regard to the common areas, their marketing emphasized the value of such amenities, and buyers were clearly willing to pay extra to have a home in a community with such items.
The IRS argued first that, regardless of this fact, the contracts did not cover the common area. The IRS points to the fact that the individual purchase and sale agreements for each home stated that it constituted the sole and entire agreement between the buyer and seller. Thus, since these contracts did not contain the details of the common areas, they simply weren’t part of the contract.
However, the Tax Court noted that the contracts made reference to documents that did contain that information. The court analyzed the laws of the states involved (Arizona, California, and Colorado) and, based on the specific laws of each state (including requirements in Arizona and California regarding receipt of a developer’s public report containing such details) and determined that, despite the specific clause, courts in all of the states would have found the documents detailing the developer’s responsibilities for the common areas to be incorporated into the contract. As well, in each case the contracts contained a checklist indicating the documents were to be given to the customers and each customer actual received the documents.
The IRS next contended that the house alone was the “subject matter” referred to in the regulations. The IRS did have one issue to deal with here—because qualification under the 80% rule would be very difficult for a builder such as this taxpayer with significant costs that are not direct costs of the dwelling unit and improvements to it, Reg. §1.460‑3(b)(2)(iii) allows a taxpayer to consider the “allocable share of the cost the taxpayer expects to incur for any common improvements.”
The IRS position was that the inclusion of these items was solely for meeting the 80% test and did not mean the items became part of the subject matter of the contract. The IRS argued this was in line with the “plain meaning” of the regulation. The Tax Court found that view wanting, holding specifically that if they were to decide upon a “plain meaning” of the subject matter, the Court would determine the subject matter would include the common improvements.
As well, the Court points to the “all facts and circumstances” clause in the second test, which it finds suggest a broad, rather than narrow, view of what constitutes the subject matter.
The IRS’s final objection is that, even if the improvements are part of the subject matter of the contract, they are nevertheless the “to be ignored” secondary items discussed in the regulations. All parties agreed that an item should be considered a “secondary item” if the contracting parties intended the item to be secondary.
The Court here finds that, in the facts in this case, the amenities were of “great importance to and a crucial aspect of SHI's, SHLP's, and Vistancia's sales effort, obtaining of governmental approval of the development, and the buyers' purchase decision, and thus the amenities are an essential element of the home purchase and sale contract.” Earlier the Court had noted that, given the expense involved with the common areas and amenities, buyers would reasonably be aware that if they were not interested in such items, they could likely obtain a comparable home for far less money in a development without such “extras” and thus they were willing to pay more.
The IRS also looked to try to use a technicality, arguing that the taxpayer had impermissibly aggregated the contracts and, regardless of whether permissible, had failed to attach the required statement with the return when contracts were aggregated. [Reg. §1.460‑1(e)(4)]
The Court noted that the method used did not actually aggregate the contracts into a single mass—rather, each contract was tested with its costs and its share of the common costs for purposes of 95% test. Similarly, the mere fact that all of the contracts looked to the promised completion of work on the amenities and development as one of their conditions for final completion and acceptance would also not be combining them all—as should be clear, each buyer’s contract contained portions only of interest to that buyer. So, if the taxpayer had completed the amenities but, say, neglected to complete work on the one buyer’s garage all other contracts may be complete, but the one would not.
While this case is generally very good news for developers of residential projects, it is important to note that the Court spent significant time on developing both the specific facts related to each project (including how each project was marketed to customers) and details of applicable state law.
Thus, any taxpayer seeking to stake out a similar position would be well advised to study the details of the facts in this case and assure that their facts are similar enough to justify reliance on this case. For instance, if there was not a homeowner’s association to be involved due to no common amenities and the only common costs were items required by a locality, it might be far more difficult to show that the buyers truly considered those items as anything but “secondary” items.
On appeal to the Ninth Circuit (Shea Homes Inc. et al. v. Commissioner, CA9, Nos. 14-72161, 14-72162, 14-72163) the IRS decided to change its argument somewhat—the agency agreed that the amenities were part of the contract, but that the Tax Court had impermissibly allowed Shea Homes to perform the 95% test against the entire cost of the development rather than simply the costs of that home and its allocable share of common area costs only.
The Ninth Circuit rejected the IRS appeal. All the judges noted that this was an argument the IRS had not raised at Tax Court, instead basing its position entirely on the full exclusion of common area elements, the position the agency now accepts as erroneous.
The majority opinion points out that, to the extent there was error at the trial court level, that error was the IRS’s (a position it seems likely the concurring judge would also accept):
The Commissioner complains that the Tax Court focused on the house, lot and common amenities in its opinion. The Commissioner then suggests that when the Tax Court mentioned the development as a whole, it was, somehow, being inconsistent. The Commissioner overlooks the fact that his focus was on those specific aspects, and those are what he specifically pointed to when he was stating his position for purposes of the trial of this case at the Tax Court. We suspect that the Commissioner was satisfied that his position on those points would win the day and, therefore, that he need not concentrate his firepower on the overall planned community development aspect of the contracts. The resulting outcome was due to his misperception rather than a Tax Court mistake.
Two of the three judges took up the IRS’s new position and rejected it out of hand, holding that the buyers had an interest on the completion of the development and not just the amenities. As the majority stated:
The Commissioner also argues that a buyer of a house cannot himself use other homes and, therefore, the development as a whole could not be part of the subject matter of the buyer's contract. That not only begs the question but also is a non sequitur. Each person in the planned community would, indeed, have an interest in the use of other property in the development, and that would include not only the common amenities but also the use that others in the development made of their own properties. That is at least one reason for the CC&R's and the mandated homeowners’ associations. It is not a question of living in another's home; it is a question of assuring that the planned lifestyle is followed to some degree. And until the Taxpayers’ work was complete, they had an obligation to fulfill their promises regarding the development that they had induced the buyers to become a part of.
However, Judge Rawlinson, in a concurring opinion, sustains the original decision solely because the IRS had not raised the matter at trial. He notes:
Our precedent is replete with cases precluding a party from endeavoring to assert a theory on appeal that was not presented to the trial court. See, e.g., Stewart v. Comm’r of Internal Revenue, 714 F.2d 977, 986 (9th Cir. 1983) (“Without question, the most appropriate times for the Commissioner to inform a taxpayer of the legal theories on which he intends to rely are first in the notice of deficiency and then in the Commissioner's answer in the Tax Court. . . .”) ( citation omitted); Ecological Rights Found. v. Pac. Gas & Elec. Co., 713 F.3d 502, 511 (9th Cir. 2013) (“The Court will not allow a party to raise an issue for the first time on appeal merely because a party believes that he might prevail if given the opportunity to try a case again on a different theory.”) (citation and alteration omitted); Tibble v. Edison Int'l., 820 F.3d 1041, 1046 (9th Cir. 2016) (“We recognize a general rule against entertaining arguments on appeal that were not presented or developed before the district court. . . . [A]n issue will generally be deemed waived on appeal if the argument was not raised sufficiently for the trial court to rule on it.”) (citations and internal quotation marks omitted).
We need go no further than consulting this precedent to resolve the instant appeal.
He then goes on to state that the majority erred both in deciding to look at the IRS’s argument and to rule on it. As well, he clearly indicates that their acceptance of the entire development as the item to be tested for 95% of the costs appears to be at odds with the regulation:
…[T]he fact remains that a Taxpayer could readily manipulate the 95 percent completion test by deliberately incurring development costs of less than 95 percent and deferring the balance of the costs indefinitely, correspondingly deferring taxes indefinitely. I am not persuaded that this interpretation of the regulation is consistent with its plain language. For that reason, I would affirm the Tax Court's decision solely on the basis that the Commissioner failed to raise this issue sufficiently for the Tax Court to rule on it. I would reserve resolution of this important issue for a case where it was fairly joined.
At this point advisers likely should take care with the status of this issue. While the Ninth Circuit majority accepted the view that the entire development is the item to be tested, it seems very possible that view might not hold in other circuits.
As well, outside the Ninth Circuit, arguably the Tax Court could view their holding as limited to the question of the inclusion of more than just the particular costs of one house without necessarily holding that the entire development is the proper item to test for 95%.
That is, the Tax Court could take the position, stated in the Ninth Circuit opinion, that as the item was never contested there was no real decision on what would be the proper measurement level. But the one thing we know for sure is that all parties agree that in a development such as this the costs for the contract are not solely limited to costs incurred on the particular lot.
The IRS itself, not unexpectedly, views the Ninth Circuit panel’s majority finding as an erroneous one and has announced, in AOD 2017-03, that the agency will not follow it except in the Ninth Circuit.
The AOD reasons:
The Service disagrees with the court’s conclusion that the 95-percent completion test can properly be applied with reference to the costs of an entire development or phase. Contract completion and the 95-percent completion test apply on a contract-by-contract basis. The latter considers “the total allocable contract costs attributable to the subject matter [of the contract].” Treas. Reg. § 1.460-1(c)(3)(i)(A). The total costs of an entire development or phase cannot be the “allocable contract costs” of each individual home construction contract. Section 1.460-4(d)(1) of the regulations provides that “a taxpayer using the CCM . . . must take into account in the contract’s completion year, . . . the gross contract price and all allocable contract costs incurred by the completion year.” If the “allocable contract costs” of a contract are the entire cost of a development or phase, this same set of costs becomes deductible multiple times as each and every individual home construction contract is completed.
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. Treas. Reg. § 1.460-1(c)(3)(i)(B). The buyer of a house, the counterparty to each of Taxpayers’ home construction contracts, has no right to use other houses in a development and has no authority to accept them.
The IRS concludes the AOD by stating:
Accordingly, the Service will not follow the Ninth Circuit Court of Appeal’s opinion in Shea Homes. Although we disagree with the decision of the court, we recognize the precedential effect of the decision to cases appealable in the Ninth Circuit, and therefore will follow it with respect to cases within that circuit, if the opinion cannot be meaningfully distinguished. We do not, however, acquiesce to the opinion and will continue to litigate our position in cases in other circuits.