FEATURE ARTICLE

 

LOT DEVELOPERS USING COMPLETED CONTRACT METHOD SHOULD EXERCISE CAUTION

 

The IRS’s Large and Mid-Size Business Division (“LMSB”) has issued a directive to its agents warning that there is a growing trend in the construction industry resulting in the improper use of the completed contract method (“CCM”). Generally, a long-term contract for the manufacture, building, installation or construction of property must be reported under the percentage-of-completion method (“PCM”). However, home construction contracts, and other real property construction contracts that satisfy a two-year test and a $10,000,000 gross receipts test, are not required to use the PCM and instead can use the CCM. Under the CCM, notwithstanding the timing of payment receipt, the taxpayer doesn’t report income until the contract is completed.

The LMSB directive contains five examples that agents are to look for. In one example, the taxpayer, a land developer, enters into a sales/construction contract to provide improved lots but is contractually obligated to make future common improvements, such as a clubhouse, pool, resurfaced roads, etc. In another, the taxpayer is a subcontractor hired by the developer to construct roadways, sidewalks, utilities and other common improvements within a residential community. In both circumstances, the taxpayers treat the contracts as home construction contracts and elect to use the CCM, thereby deferring the recognition of income until all of the contracted improvements are completed.

A home construction contract is a construction contract where at least 80% of the estimated total contract costs is reasonably expected to be attributed to the building, construction, reconstruction or rehabilitation of dwelling units in buildings containing no more than four dwelling units and improvements to the building’s associated real property. The LMSB directive indicates that a team is currently working to clarify the definition of “home construction contract” with particular application to the above-described examples.

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David Kern is a Shareholder and a member of the Business Law, Health & Medicine and Trusts & Estates Practice Groups.  He can be reached at dkern@bdblaw.com or 330.258.6489. Andrew Bernat is an Associate in the Business Law Practice Group.  He can be reached at abernat@bdblaw.com or 330.258.6504.