The IRS recently announced its disagreement with the Ninth Circuit’s ruling that, with respect to planned communities, the 95% test under the completed contract method of accounting applies on a development-wide basis rather than a contract-by-contract basis. See Action on Decision 2017-03 (April 13, 2017). Under the completed contract method, a home construction contract is considered completed on the earlier of: (1) the first date upon which the buyer is using the property for its intended purpose and 95% of the total costs have been incurred by the taxpayer; or (2) the date upon which there is final completion and acceptance of the contract’s subject matter.
The taxpayers in Shea Homes, Inc. v. Commissioner, 142 T.C. No. 3 (2014), developed planned residential communities that included common improvements. The taxpayers reported income from sales of homes in the communities using the completed contract method of accounting. The taxpayers determined that a contract was complete once the taxpayer had incurred 95% of the total costs of construction, including any common improvements. The IRS determined that the taxpayers should have reported income in the year in which the escrow for each contract closed. The Tax Court concluded that: (1) for purposes of the 95% prong of the completion test, the taxpayers properly analyzed all of the costs incurred, including the costs of any common improvements; and (2) for purposes of the final completion and acceptance prong, the taxpayers properly decided that final completion occurred upon completion of the entire community. A more detailed description of the Tax Court’s holding can be found here. The U.S. Court of Appeals for the Ninth Circuit affirmed the Tax Court’s holding.
In its Action on Decision, the IRS announced that it disagreed with the Ninth Circuit’s conclusion. Rather than applying the 95% test to the total costs of the entire development, the taxpayer should report income when 95% of the costs with respect to a particular contract have been incurred. Although the IRS will follow the Ninth Circuit’s holding in cases appealable to the Ninth Circuit, the IRS will not follow this holding in cases appealable to other circuits. Accordingly, taxpayers that develop planned communities should be aware that there is a split in the law on this issue.
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