The recent Tax Court decision in Shea Homes, Inc. and Subsidiaries (Shea), et al. v. Commissioner will reshape how some residential developers and homebuilders view application of the completed contract method for recognizing income. Under the completed contract method of accounting, income is recognized upon the completion of the "subject matter" of the contract. A contract is considered complete at the earlier of two tests:
- the 95% completion test, or
- the final completion and acceptance test
Shea's “subject matter” of the contract extended beyond the individual home and lot and included the larger development, amenities and other common improvements as well. Shea emphasized the features and the lifestyle of its communities to potential buyers as an important element of the development, and it noted the requirements set forth in performances bonds and CC&Rs. Accordingly, Shea computed the 95% completion test by comparing the development’s total direct (representative of the actual “bricks and sticks” costs of home construction) and indirect costs to the development’s total budgeted direct and indirect costs. Under its methodology, Shea deferred income for all homes sold until the development’s incurred cost were equal to or greater than 95% of its budgeted cost.
The IRS argued that “subject matter” of the contract was the individual home and lot, and accordingly, Shea should recognize income as each home was sold. The Court agreed with Shea noting that the IRS analysis of ‘subject matter’ was “simplistic and short sighted,” and did “not acknowledge the complex relationships created by the purchase and sales agreement.”
Residential developers and homebuilders should keep this case in mind, as it will open the door for some tax planning opportunities.
If you have questions about the key provisions of the case and how those provisions will shape taxation, structuring, and financing for residential developments going forward, contact Steve Dunavant, Senior Managing Director, at email@example.com or 901.685.5575.