July 06, 2015
The tax law has for many decades and in perhaps uncountable ways afforded special treatment to specifically chosen activities in a manner intended to generate or nurture desired conduct. Charity: good. Homeownership: good. While the voices calling for comprehensive reform are loud and growing louder, our matrix of tax law, with its design to incentivize and achieve good results, seems to remain a fixture and so, if we want to achieve something, shouldn't we pursue our goal with guns blazing?
For example, our tax law recognizes the foundational importance of, and promotes, American residential communities, places where people build and share their lives, together, creating the bonds that fortify our society. To this end, America's residential developers are permitted to delay reporting and paying tax on income earned from residential construction contracts until these contracts are complete. While the U.S. government certainly prefers to collect taxes expeditiously, the policy goal underlying this particular deferral regime is considered even more important. The policy goal? America's residential communities—its "villages"—represent the fabric of our society; our tax law understands this and creates incentives toward the building and population of American communities. The completed contract method, allowed under our tax law only for the builders of America's homes, is especially tailored so as to delay tax payments and to create breathing room to make ends meet as they cobble together America's communities.
We should ask ourselves, though, whether our tax rules are doing as good a job as they might in pursing this noble goal and providing clear guidelines with which to accomplish it. Two recent high profile cases, one involving Shea Homes and the other involving Howard Hughes Company, have altered the tax landscape for residential developers in meaningful ways, highlighting the shortcomings of, and demanding renewed focus on, this area of our tax law.
In Shea Homes v. C.I.R., the Tax Court awarded a big victory to residential developers. The completed contract method allows deferral of tax until a contract is "completed," and in Shea the court said that, in the right circumstances, the completion date—the time when taxes would finally become due—is not when construction of a home is finished and a family moves in, but rather completion arrives only after the promised community in its entirety is "complete." In the absence of this special tax accounting method, the tax code generally would require taxpayers to determine taxable income from long-term construction contracts under the less favorable percentage-of-completion method. The percentage-of-completion method, applicable to certain contracts that span more than a year, requires periodic payment of taxes as the project progresses toward completion. Under this method, tax payments generally are based on the percentage of the job completed as of the end of each year. Because (among other things) this method is not linked to receipts, it has the potential to leave taxpayers cash-strapped to pay their tax obligations when project costs outpace revenues. It was recognition of this potential hardship that caused Congress in 1988 to provide greater support and incentives to an important constituency of taxpayers—America's homebuilders—that resulted in the enactment of the completed contract method.
Generally, the completed contract method provides that taxpayers may defer paying income tax on certain home construction contracts until the contracts are completed. In Shea, the homebuilder argued that finishing construction of a given housing unit is not completion of the contract because the home unit buyer has contracted for much more than just the unit. The home unit buyer, according to this argument, contracted for and was entitled to a community, complete with neighbors, common areas and other amenities, such as roads, sewers, recreation centers, golf courses and club houses. Under this way of viewing the contractual relationship between builder and buyer, the job cannot be said to be "complete"—and tax is not due—until the homebuilder is finished with and delivers the entire community. The IRS argued for a narrower application of the method, asserting essentially that the contract is "complete" and taxes are due when the home is finished and the buyer moves in.
The court in Shea agreed with the homebuilder. These rules, as understood by the court, establish a large—one could say "community-wide"—net around the costs that will be taken into account before the homebuilder is asked to pay tax. In effect, Shea advances the notion that, to respect and apply Congress' 1988 motivations, we must appreciate that the "American Dream" does not mean simply owning a home; rather, it means being part of an American community of homeowners. Shea appears to introduce a meaningful expansion of the way we understand and apply these rules, a perceived victory for the homebuilders of America. Nevertheless, this case leaves a number of unanswered questions, particularly regarding when a homebuilder can rely on the underlying principles and how far the principles can be extended.
Several months later, in Howard Hughes Co. v. C.I.R., the very same court tempered this victory. The court was asked whether the completed contract method is available to a developer of residential communities even if he does not actually build and sell individual home units. No one disputes that enactment of this special rule represented a clear Congressional commitment to the residential construction industry, a bedrock of American society. The question, though, is just how broad is that favored industry? Does it apply only to the person at the end of the process, the person who actually builds and sells units? Or should it also apply to the person who does the essential work that leads up to that final point, the person who takes raw land and does all the things necessary to create a platform on which a builder can begin to construct residential housing units?
The IRS' answer to this question is clear. It believes the completed contract method is available only to taxpayers who actually build homes. The IRS draws a hard line, and maintains that the completed contract method is not available to land developers who do not actually build and sell homes, even though they may build the infrastructure such as "roads, curbs, gutters, and utilities" and even though they may build "common amenities and recreational facilities."
This IRS position was tested in its litigation with Howard Hughes Company, which reported income from its contracts to sell developed land to homebuilders on the completed contract method even though it was under no contractual obligation itself to build homes. Howard Hughes Company argued that if homebuilders can consider all of their community-wide development costs in determining whether their contracts are complete—a la Shea—then a developer should surely be able to rely on the completed contract with respect to its contracts to build common improvements in residential communities (such as pools and police stations), even though it did not "build the four walls or roof of a dwelling unit." The court disagreed.
The court in Hughes was persuaded by the IRS' arguments that home construction contracts cannot consist solely of common improvements; the taxpayer must actually build a home. While the court acknowledged that Howard Hughes Company's development work was "necessary for the ultimate home to feasibly be built and occupied," it found that these development costs were too "tangentially related to a dwelling unit … to be counted in determining whether a contract is a home construction contract." The court acknowledged the tension with its opinion in Shea, but nonetheless decided that merely paving the road leading to the home is not enough to qualify for the completed contract method. The court worried that allowing use of the completed contract method by developers who don't actually build homes, who incur construction costs that merely benefit a home that may or may not ever be built, could lead to an expansion of the rule way beyond its intended target of homebuilders.
Thus, the court in Hughes disallowed use of the completed contract method by a developer and builder of residential infrastructure, establishing (or clarifying) that this Congressional assistance afforded to the builders of America's communities is available only to actual builders and sellers of homes and not to those who merely develop property for use as a residential community. Apparently, the developer who starts with raw land and takes all the steps—and incurs all the expenses—necessary to create the platform for a residential community is not to receive the same Congressional incentive as the homebuilder to whom he hands off the developed land. Thus, within the span of several months, the Tax Court (in Shea) extended deferral opportunities under the completed contract method but then (in Hughes) narrowed the class of taxpayers who may benefit from them.
How should we understand these developments? What is the best approach going forward? As we see in Shea, the completed contract method remains an essential element supporting an industry that is of fundamental importance to our society. We see a court recognizing that these rules are intended to be applied, and will only work if applied, expansively in a way that allows a residential community builder to build and deliver the community without running out of money as a result of accelerated tax payments. Thus, Shea Homes was permitted to delay paying taxes well beyond the early sales of home units and instead was permitted to defer payment of taxes until the larger community was populated and built. Yes, we are left with uncertainty as to how far this holding can be taken, but there can be no doubt that it reflects a deep understanding of the business realities and the underlying stakes. But then Hughes comes along, making us wonder just how far we think any of this can be taken. And just how far we think it ought to be taken.
The concern underlying both cases is clear—that an expansive reading of the completed contract method will lead to abusive deferral. In both cases, the court was confronted with and seriously considered the argument that the completed contract method represents a special and limited rule that must be allowed as intended but that must not be allowed beyond that. Unlike in Shea, however, in Hughes the court acceded to this concern and drew a line in the sand, choosing to simply shut the door on an entire segment of the residential community building industry. The court was guided by the principal that (in its words) "deferral of income tax, like exemptions and deductions, is a matter of legislative grace, and exceptions to the normal income recognition rules must be strictly construed." As understood by the court, in exercising this legislative grace Congress was addressing the risk that homebuilders would incur and be required to pay tax before they had sufficient cash with which to pay the tax. Congress recognized that this extra financial burden incurred by homebuilders would, in some way, be borne by the end users of home construction contracts—America's homebuyers. Even while recognizing all of this, however, the court in Hughes decided that construction costs too far removed from the actual dwelling unit don't always give rise to the creation of homes, and therefore should not qualify for the tax deferral. The court decided that a line had to be drawn, and chose to allow only those who actually build homes to qualify for this rule.
Although the concern that ultimately persuaded the court in Hughes is a valid one and must be addressed, one wonders whether the court went too far, whether the court drew the line at a place that actually undermines rather than advances the very Congressional goals the court hoped to protect. The revenue and cost profile of a community developer typically is similar to the profile of the actual home builder, and so the developer is subject to similar cash-flow challenges if presented with "early" tax bills. And it cannot be denied that the developer plays an equally vital role in delivering affordable houses to America's homebuyers. So why draw the line disqualifying developers from using the special tax deferral rule? If subjected to a harsher tax landscape, these developers can be expected either to opt out of the system altogether or to pass on their higher costs, which would frustrate the objective of the completed contract method.
While the court in Hughes may have been overly restrictive in drawing the line where it did, maybe the court in its approach in Shea was too liberal. Perhaps the court in Shea should have drawn its own line or two. The court correctly concluded that the subject matter of a contract for purposes of allocating costs under the completed contract method could include more than just the actual home. However, it did not provide clear guidelines as to how far this conclusion may be taken, and in that way may have invited future builders to take the principles too far. For example, the court in Shea failed to clarify which costs are not covered under the rules and failed to tell us how far is too far. The court in Shea chose to avoid this important element of interpreting and applying the rules in this area by explaining that since the tax regulations do not define so-called "secondary items" in a contract, the costs of which cannot be taken into account in order to defer tax liability, the question should be answered "by reference to the facts and intent of the contracting parties." Taken to its extreme, this interpretation suggests that parties can avoid the "taint" of secondary items by simply labeling them "primary." Presumably that is not what Congress intended.
The court's failure in Shea to address this and other important issues underlying the proper application of the completed contract method leaves America's homebuilders without clear guidance as to how to apply the method going forward. Furthermore, this ruling leaves the completed contract method at risk for abuse. The court acknowledged as much in concluding that its opinion "could lead taxpayers to believe that large developments may qualify for extremely long, almost unlimited deferral periods." One is left to wonder whether this result truly is what Congress had in mind.
While Shea was certainly a step in the right direction, its unanswered questions leave America's home builders in limbo. At the same time, the court's narrow reading of the completed contract method in Hughes leaves America's developers out in the cold. Do these cases achieve the appropriate policy goals? Do they advance Congress' intent in enacting the completed contract method? The IRS has appealed Shea and Howard Hughes Company has appealed its case; perhaps the higher courts will provide needed direction. Or perhaps Congress will take the reins and clarify the ambiguities in its intent that these cases have brought to light. Time will tell.
Mark Hoenig is a partner and Scott Fryman is an associate at Weil, Gotshal & Manges.
Reprinted with permission from the July 6, 2015 issue of New York Law Journal. © 2015 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.