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Stephen Ehrenberg
Stephen Ehrenberg

The completed-contract method

A recent Tax Court decision is important for long-term contract accounting.

March 27, 2014
by Stephen J. Ehrenberg, CPA

The recognition of income and expenses for both book and tax purposes varies widely among industries. As taxpayers across these industries analyze cases and other guidance underlying income and expense recognition, they frequently find opportunities to review and revise existing accounting methods. One industry in particular, the home-building industry, may have an expanded opportunity to defer the recognition of income until contract completion as a result of the February decision of the Tax Court in Shea Homes, Inc., 142 T.C. No. 3 (2014).

Long-term contract accounting

Sec. 460 governs the treatment of long-term contracts. The rules generally require taxpayers with long-term contracts to use the percentage-of-completion method to determine the accounting period in which taxable income is recognized.

Sec. 460(f) defines a long-term contract to mean any contract for the manufacture, building, installation, or construction of property if the contract is not completed within the tax year in which the contract is entered into. Provided the underlying contract meets this definition, taxpayers then calculate the cumulative percentage of the contract that is completed annually by comparing costs allocated to the contract and those incurred before the close of the tax year over the estimated contract costs (Sec. 460(b)(1)(A)). The ratio of these costs over the total estimated costs is then multiplied by the contract price to derive the income recognized in a given accounting period.

Completed-contract accounting

As with many Code provisions, there are exceptions to the general rule requiring the application of the percentage-of-completion method to derive annual income recognition for qualifying long-term contracts. From simplified cost allocation to de minimis exceptions, taxpayers are given some latitude in applying these rules. In addition to these exceptions, eligible taxpayers in the home construction business may also be able to apply the provisions of Sec. 460(e)(1)(a), thus deferring recognition of income until the underlying contract is completed.

Shea Homes

Shea Homes, one of the largest privately owned home builders in the United States, is one such eligible taxpayer. For more than 40 years, Shea Homes has sought to not only develop homes, but also to develop communities where families can live for generations. This difference from traditional builders was central to Shea Homes’ argument in the Tax Court—the homebuilder sought to defer the recognition of income on the homes it built and sold until “the last road is paved and the final bond is released.”

Whereas the percentage-of-completion method requires taxpayers to recognize income on long-term contracts as work progresses, the completed-contract method allows taxpayers to defer recognition of income until the test under Regs. Sec. 1.460-1(c)(3)(i) is met. This regulation provides a bright-line test, stating that a contract is complete upon the earlier of:

  • When the customer is using the property that is the subject matter of the contract for its intended purposes (other than for testing) and the taxpayer has incurred at least 95% of the total allocable contract costs attributable to the subject matter of the contract; or
  • When the subject matter of the contract has been finally completed and accepted.

This “contract completion test” was the critical point to Shea Homes’ argument. Shea Homes contended that it was in the business of building and developing communities, not just homes. As such, the mere completion of the home and transfer of the lot to the respective buyer did not signal the completion of the contract. Rather, the completion of the common area that is shared by all the homeowners within the respective community, Shea Homes stated, marked the true completion of the contract.

The IRS, however, took a different position. It argued that the common areas in the developments were secondary items and, as such, were excluded in determining whether the contract was 95% complete under  Regs. Sec. 1.460-1(c)(3)(ii). Shea Homes argued that the common areas were not secondary items and, therefore, that it could include their allocable costs in applying the 95% test.

The Tax Court’s holding

It is noteworthy that the Tax Court sided with the taxpayer in this case, potentially opening the door for many large-scale home developers to revisit their revenue recognition methods. The Tax Court’s decision focused on the common area improvements in each development to determine if the contract-completion test referenced above was met.

The IRS sought to separate the lot where the actual home was constructed from the remainder of the community, but Shea Homes successfully argued that the construction was not complete until the earlier of when:

  • 95% of the total costs of the community as a whole are incurred; or
  • The community as a whole is completely finished.

Recommendation to taxpayers

While many long-term contracts are accounted for through the percentage-of-completion method, the decision in Shea Homes certainly brings an important consideration to the forefront for home developers and builders. Large-scale home developers, in particular, should examine fact patterns on current contracts, as well as opportunities on future contracts, to determine if the facts of this case are similar to their own.

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Stephen J. Ehrenberg, CPA, is a tax principal in the Los Angeles office of Holthouse Carlin & Van Trigt LLP.