SCOTUS Reports

Tag: Percentage of Completion Method

  • Howard Hughes Co., LLC v. Comm’r, 142 T.C. 355 (2014): Long-Term Construction Contracts and Home Construction Contract Exception

    Howard Hughes Co. , LLC v. Commissioner of Internal Revenue, 142 T. C. 355 (2014)

    In Howard Hughes Co. , LLC v. Comm’r, the U. S. Tax Court ruled that the company’s land sale contracts for a master-planned community were long-term construction contracts but not home construction contracts under IRC sec. 460(e). This meant the company could not use the completed contract method of accounting, impacting how it recognized income from land sales in Summerlin, Nevada. The decision clarifies the scope of the home construction contract exception, affecting developers and the timing of income recognition in similar real estate projects.

    Parties

    Howard Hughes Co. , LLC, and Howard Hughes Properties, Inc. , were the petitioners in this case. The Commissioner of Internal Revenue was the respondent. The petitioners were involved in a tax dispute regarding their method of accounting for income from land sales in the Summerlin master-planned community.

    Facts

    Howard Hughes Co. , LLC, and its subsidiaries (collectively, Howard Hughes) were engaged in developing and selling land in the Summerlin community in Las Vegas, Nevada. The land sales were categorized into bulk sales, pad sales, finished lot sales, and custom lot sales. Howard Hughes sold land to builders and individual purchasers, but did not construct residential units on the land sold. For the tax years 2007 and 2008, Howard Hughes reported income from these sales under the completed contract method of accounting, claiming the contracts qualified as home construction contracts under IRC sec. 460(e).

    Procedural History

    The Commissioner of Internal Revenue issued notices of deficiency to Howard Hughes for the tax years 2007 and 2008, asserting that Howard Hughes should use the percentage of completion method of accounting rather than the completed contract method. Howard Hughes timely petitioned the U. S. Tax Court for a redetermination of the deficiencies. The case was tried in Las Vegas, Nevada, and consolidated for trial, briefing, and opinion.

    Issue(s)

    Whether Howard Hughes’s contracts for the sale of land in Summerlin qualify as long-term construction contracts under IRC sec. 460(f)(1)?
    Whether Howard Hughes’s contracts for the sale of land in Summerlin qualify as home construction contracts under IRC sec. 460(e)(6), thereby allowing the use of the completed contract method of accounting?

    Rule(s) of Law

    A long-term contract is defined by IRC sec. 460(f)(1) as “any contract for the manufacture, building, installation, or construction of property if such contract is not completed within the taxable year in which such contract is entered into. ” A home construction contract under IRC sec. 460(e)(6) is a construction contract where 80% or more of the estimated total contract costs are attributable to activities related to dwelling units in buildings containing four or fewer units and improvements to real property directly related to such units and located on the site of such dwelling units. The regulations further clarify that common improvement costs can be included in the cost of dwelling units if the taxpayer is obligated to construct them.

    Holding

    The Tax Court held that Howard Hughes’s bulk sale and custom lot contracts were long-term construction contracts under IRC sec. 460(f)(1). However, the court also held that Howard Hughes’s contracts were not home construction contracts within the meaning of IRC sec. 460(e)(6), and therefore, Howard Hughes could not use the completed contract method of accounting for these contracts.

    Reasoning

    The court reasoned that Howard Hughes’s contracts were long-term construction contracts because they involved the construction of property that was not completed within the taxable year the contracts were entered into. The court rejected the Commissioner’s argument that custom lot contracts were not long-term contracts because they were completed within the same tax year, finding that the subject matter of these contracts included more than just the sale of the lot, such as infrastructure improvements whose costs were allocable to the contracts.

    Regarding the home construction contract exception, the court strictly construed the statute and regulations, finding that Howard Hughes’s contracts did not qualify because they did not involve the construction of dwelling units or improvements directly related to and located on the site of such units. The court determined that the costs Howard Hughes incurred were for common improvements and not attributable to the construction of dwelling units, as Howard Hughes did not build the homes or improvements on the lots sold. The court distinguished this case from Shea Homes, Inc. & Subs. v. Commissioner, where the taxpayer both developed land and constructed homes, allowing the inclusion of common improvement costs in the 80% test for home construction contracts.

    The court also considered the legislative history and purpose behind the home construction contract exception, concluding that it was intended to benefit homebuilders who construct dwelling units, not land developers who only prepare the land for future construction by others. The court emphasized that allowing Howard Hughes’s interpretation would lead to an overly broad application of the exception, potentially resulting in indefinite deferral of income recognition.

    Disposition

    The Tax Court entered decisions for the respondent, the Commissioner of Internal Revenue, denying Howard Hughes’s use of the completed contract method of accounting for the contracts at issue.

    Significance/Impact

    The Howard Hughes decision clarifies the scope of the home construction contract exception under IRC sec. 460(e)(6), impacting how land developers and builders account for income from land sales and construction projects. The ruling underscores that the exception is narrowly construed and applies primarily to taxpayers who directly construct qualifying dwelling units, not those who merely develop land for future construction by others. This case sets a precedent for distinguishing between land development and home construction activities for tax purposes, affecting the timing of income recognition and potentially influencing business strategies in real estate development. Subsequent cases and IRS guidance may further refine the application of the exception based on this decision.

  • The Howard Hughes Co., LLC v. Commissioner, 142 T.C. No. 20 (2014): Long-Term Construction Contracts and Accounting Methods

    The Howard Hughes Co. , LLC v. Commissioner, 142 T. C. No. 20 (2014)

    In a significant ruling, the U. S. Tax Court determined that The Howard Hughes Company, a land developer, could not use the completed contract method of accounting for its land sales contracts, as they did not qualify as home construction contracts under IRC section 460(e). The court clarified that only taxpayers directly involved in building homes or related improvements could use this method, impacting how land developers account for income from sales to homebuilders.

    Parties

    The Howard Hughes Company, LLC (formerly The Howard Hughes Corporation) and its subsidiaries, along with Howard Hughes Properties, Inc. , were the petitioners in these cases. They were engaged in residential land development in Las Vegas, Nevada. The respondent was the Commissioner of Internal Revenue, representing the interests of the U. S. government in tax matters.

    Facts

    The Howard Hughes Company and Howard Hughes Properties, Inc. , were involved in developing land in the Summerlin area of Las Vegas, Nevada. They sold land to builders and individuals through various methods including bulk sales, pad sales, finished lot sales, and custom lot sales. The company did not construct homes on the land sold but developed necessary infrastructure. For tax years 2007 and 2008, they reported income from these sales using the completed contract method of accounting, which the IRS challenged, asserting the percentage of completion method should be used instead.

    Procedural History

    The IRS issued notices of deficiency to The Howard Hughes Company and Howard Hughes Properties, Inc. , for the tax years 2007 and 2008, claiming they improperly used the completed contract method of accounting. The petitioners contested these deficiencies in the U. S. Tax Court, which consolidated the cases for trial, briefing, and opinion. The court reviewed the applicable law under IRC section 460 and considered whether the contracts qualified as home construction contracts.

    Issue(s)

    Whether the contracts for the sale of land by The Howard Hughes Company and Howard Hughes Properties, Inc. , qualify as home construction contracts under IRC section 460(e), allowing them to use the completed contract method of accounting?

    Rule(s) of Law

    IRC section 460(e) defines a home construction contract as one where 80% or more of the estimated total contract costs are attributable to activities related to building, constructing, reconstructing, or rehabilitating dwelling units or improvements directly related to such units. The regulations further clarify that these costs must be directly attributable to the construction of the dwelling units or related improvements.

    Holding

    The U. S. Tax Court held that the contracts of The Howard Hughes Company and Howard Hughes Properties, Inc. , did not qualify as home construction contracts under IRC section 460(e). Therefore, they could not use the completed contract method of accounting for their land sales. However, the court recognized that the custom lot contracts and bulk sale agreements were long-term construction contracts, allowing for the use of an alternative permissible method of accounting, such as the percentage of completion method.

    Reasoning

    The court’s reasoning focused on the interpretation of IRC section 460(e) and its regulations. The court determined that the costs incurred by The Howard Hughes Company were not directly attributable to the construction of dwelling units but rather to infrastructure development. The court emphasized that the completed contract method of accounting is a narrow exception intended for taxpayers directly involved in home construction, not land developers who do not build homes. The court also considered the legislative intent behind the home construction contract exception and found that it was meant to benefit homebuilders, not land developers. The court rejected the petitioners’ argument that their costs were related to and located on the site of the dwelling units, as they did not construct the homes or prove that qualifying dwelling units were built.

    Disposition

    The court entered decisions in favor of the respondent, the Commissioner of Internal Revenue, denying the petitioners’ use of the completed contract method of accounting for their land sales contracts.

    Significance/Impact

    This case clarifies the scope of the home construction contract exception under IRC section 460(e), impacting how land developers account for income from land sales to homebuilders. It establishes that only taxpayers directly involved in building homes or related improvements can use the completed contract method of accounting. The ruling may lead to changes in how land developers structure their contracts and account for income, potentially affecting their tax planning strategies. It also highlights the importance of strict interpretation of tax exceptions and the need for clear evidence that qualifying dwelling units will be constructed to qualify for such exceptions.

  • Shea Homes, Inc. v. Commissioner, 142 T.C. No. 3 (2014): Application of the Completed Contract Method for Home Construction Contracts

    Shea Homes, Inc. v. Commissioner, 142 T. C. No. 3 (2014)

    In Shea Homes, Inc. v. Commissioner, the U. S. Tax Court ruled in favor of the homebuilder, allowing them to use the completed contract method for accounting income from home sales in planned developments. The court determined that the subject matter of the home purchase contracts included the entire development, not just individual homes, thus permitting income deferral until 95% of the development’s costs were incurred. This decision clarifies the scope of home construction contracts under tax law and has significant implications for how homebuilders account for income from large-scale projects.

    Parties

    Shea Homes, Inc. , and its subsidiaries, Shea Homes, LP, and Vistancia, LLC, were the petitioners in this case. They were represented by Gerald A. Kafka, Rita A. Cavanagh, Chad D. Nardiello, and Sean M. Akins. The respondent was the Commissioner of Internal Revenue, represented by Melissa D. Lang, Allan E. Lang, David Rakonitz, and Nicholas D. Doukas.

    Facts

    Shea Homes, Inc. , and its subsidiaries, Shea Homes, LP, and Vistancia, LLC, are home developers that build large, planned residential communities across multiple states. They reported income from home sales using the completed contract method of accounting, which allowed them to defer income until they met the 95% cost completion threshold for each development. The Commissioner challenged this method, asserting that the subject matter of the contracts consisted only of the homes and lots, not the broader development, and that income should be recognized upon the close of escrow for each home sale.

    Shea Homes, Inc. , and its subsidiaries maintained detailed budgets and used Tract-PIE software to track costs and revenues for each development. They argued that the subject matter of their home purchase contracts included the entire development, including amenities and infrastructure, which influenced the cost calculations for the 95% completion test.

    Procedural History

    The case was heard in the U. S. Tax Court, with Shea Homes, Inc. , and its subsidiaries challenging the Commissioner’s determination of tax deficiencies for the tax years 2004 and 2005. The court consolidated the cases involving Shea Homes, LP, and Vistancia, LLC, and reviewed the notices of final partnership administrative adjustments issued by the Commissioner for the tax years 2004, 2005, and 2006. The standard of review was de novo, as the court was tasked with determining whether the completed contract method of accounting was properly applied by the petitioners.

    Issue(s)

    Whether the subject matter of the home purchase contracts between Shea Homes, Inc. , and its subsidiaries and homebuyers includes the entire development, thus permitting the use of the completed contract method of accounting for income recognition?

    Rule(s) of Law

    Under section 460 of the Internal Revenue Code, taxpayers who receive income from long-term contracts must generally use the percentage of completion method, but home construction contracts are exempted and may use the completed contract method. A contract is considered completed under the completed contract method when it meets either the use and 95% completion test or the final completion and acceptance test. The regulations under section 460 allow taxpayers to include the allocable share of costs for common improvements in determining if a contract qualifies as a home construction contract.

    Holding

    The U. S. Tax Court held that the subject matter of the home purchase contracts included the home, the lot, improvements to the lot, and the common improvements in the development. Consequently, Shea Homes, Inc. , and its subsidiaries were permitted to report income and losses from home sales using their interpretation of the completed contract method of accounting.

    Reasoning

    The court’s reasoning focused on the interpretation of the subject matter of the home purchase contracts. It rejected the Commissioner’s argument that the contracts were limited to the house and the lot, finding instead that the contracts encompassed the entire development or phase of the development, including amenities and infrastructure. This broader interpretation was supported by the inclusion of public reports, covenants, conditions, and restrictions (CC&Rs), and other documents provided to homebuyers, which indicated that the purchase included rights to use common areas and amenities.

    The court also considered the practical implications of the homebuilders’ business model, which involved significant upfront costs for land acquisition, grading, utilities, and infrastructure before any home sales occurred. The completed contract method was deemed appropriate for matching these costs with the revenues from home sales over time.

    The court addressed the Commissioner’s contention that common improvements should be treated as secondary items, separate from the primary subject matter of the contract. It found that the common improvements were integral to the home purchase contracts and not secondary items, as they were essential to the lifestyle and value proposition marketed to homebuyers.

    Finally, the court concluded that the completed contract method, as applied by Shea Homes, Inc. , and its subsidiaries, clearly reflected income under section 446(b) of the Internal Revenue Code. The method was consistent with the legislative intent behind the home construction contract exception and allowed for a reasonable deferral of income given the nature of the homebuilding industry.

    Disposition

    The court entered decisions in favor of the petitioners, Shea Homes, Inc. , and its subsidiaries, allowing them to continue using the completed contract method of accounting for their home construction contracts.

    Significance/Impact

    The Shea Homes decision is significant for the homebuilding industry, as it clarifies the scope of home construction contracts under tax law. By recognizing that the subject matter of such contracts can include the entire development, the court affirmed the use of the completed contract method for large-scale projects, which can involve significant upfront costs and long-term planning. This ruling may influence how other homebuilders structure their contracts and account for income, potentially affecting tax planning and financial reporting practices industry-wide. The decision also underscores the importance of considering all contractual documents and the broader context of home sales in planned communities when applying tax accounting methods.

  • Tutor-Saliba Corp. v. Commissioner, 115 T.C. 1 (2000): When to Include Disputed Claims in Long-Term Contract Income

    Tutor-Saliba Corp. v. Commissioner, 115 T. C. 1 (2000)

    Disputed claims must be included in the estimated contract price for long-term contracts under the percentage of completion method when it is reasonably estimated that they will be received.

    Summary

    Tutor-Saliba Corp. challenged the validity of an IRS regulation requiring the inclusion of disputed claims in the estimated contract price for long-term contracts reported under the percentage of completion method. The Tax Court upheld the regulation, finding it consistent with the statutory language and purpose of section 460. The court reasoned that the regulation’s requirement to include disputed claims when reasonably expected to be received aligns with the statute’s goal of reducing income deferral and is supported by the legislative history’s use of terms like ‘expected’ and ‘anticipated’. This decision has significant implications for how long-term contract income is reported and the potential interest obligations under the look-back method.

    Facts

    Tutor-Saliba Corp. , a California-based general contractor, entered into fixed-price long-term contracts for construction projects. These contracts often led to disputes over additional work required due to changes or delays. Tutor-Saliba reported income from these contracts using the percentage of completion method but did not include income from disputed claims until they were resolved, in accordance with the all events test. The IRS, however, required the inclusion of disputed claims in the estimated contract price as soon as it was reasonably estimated that they would be received, as per section 1. 460-6(c)(2)(vi) of the Income Tax Regulations.

    Procedural History

    Tutor-Saliba filed a motion for partial summary judgment in the U. S. Tax Court, challenging the validity of the IRS regulation requiring the inclusion of disputed claims in the estimated contract price. The Tax Court denied the motion, upholding the regulation as a valid interpretation of section 460.

    Issue(s)

    1. Whether section 1. 460-6(c)(2)(vi) of the Income Tax Regulations, which requires the inclusion of disputed claims in the estimated contract price when it is reasonably estimated that they will be received, is a valid interpretation of section 460 of the Internal Revenue Code?

    Holding

    1. Yes, because the regulation harmonizes with the plain language, origin, and purpose of section 460, and is a reasonable interpretation of the statute.

    Court’s Reasoning

    The court applied the Chevron standard of review, focusing on whether the regulation was a reasonable interpretation of the statute. The court found that the term ‘estimated’ in section 460 did not preclude the inclusion of disputed claims and that the regulation did not contradict the statute’s plain language. The court also considered the legislative history, noting that Congress intended to limit income deferral by mandating the percentage of completion method and providing for a look-back method. The regulation’s requirement to include disputed claims when reasonably expected to be received was seen as consistent with this intent, as it would reduce the likelihood of look-back interest due to income deferral. The court rejected Tutor-Saliba’s argument that the all events test should apply, stating that section 460 created a self-contained accounting method that did not necessarily incorporate the all events test. The court also found that the regulation’s ‘reasonable expectancy’ standard, while potentially difficult to apply, was not a reason to invalidate it.

    Practical Implications

    This decision requires taxpayers to include disputed claims in the estimated contract price as soon as they can reasonably expect to receive them, rather than waiting until the claims are resolved. This may lead to earlier income recognition and potentially reduce the amount of look-back interest owed. Taxpayers and practitioners must now assess when it is reasonably foreseeable that disputed claims will be received, which may involve case-by-case determinations. The decision also reaffirms the IRS’s authority to issue interpretive regulations that reasonably implement the statutory intent, even if they depart from traditional accrual accounting principles like the all events test. Subsequent cases have applied this ruling in determining the timing of income recognition for long-term contracts, and it has influenced how taxpayers approach their accounting and tax planning for such contracts.

  • Foothill Ranch Co. Pshp. v. Commissioner, 110 T.C. 94 (1998): Applying the Percentage of Completion Method for Long-Term Contracts

    Foothill Ranch Co. Pshp. v. Commissioner, 110 T. C. 94 (1998)

    The court clarified that a contract may be considered long-term under the percentage of completion method if construction is necessary to fulfill contractual obligations, even if it is not the primary subject matter of the contract.

    Summary

    Foothill Ranch Company Partnership (FRC) used the percentage of completion method (PCM) to report income from property sales, which the IRS challenged. The Tax Court held that FRC was entitled to use PCM as the construction obligations were necessary to fulfill the sales contracts, despite not being the primary focus. The court also ruled on the eligibility for litigation costs, stating that first-tier partners meeting net worth requirements could receive awards proportional to their partnership interest. The decision has implications for tax reporting under PCM and the allocation of litigation costs in partnership disputes.

    Facts

    In 1987, Laguna Niguel Properties purchased the Whiting Ranch and exchanged it for an interest in FRC. FRC entered into an agreement with Orange County in 1988 to build housing units and other improvements in exchange for construction permits. FRC also sold parcels to Lyon Communities, Inc. , and P. B. Partners, with FRC obligated to fulfill construction commitments. FRC used the PCM to report income from these transactions on its 1988 tax return. The IRS issued a Notice of Final Partnership Administrative Adjustment in 1995, challenging FRC’s use of PCM, leading to the litigation.

    Procedural History

    FRC filed a petition in response to the IRS’s notice. The IRS initially moved to dismiss for lack of jurisdiction due to an improper designation of the tax matters partner, but this was denied after FRC amended the petition. The parties settled the case without adjustments to FRC’s reported income, and FRC moved for litigation costs.

    Issue(s)

    1. Whether the IRS’s position that FRC was not entitled to use the PCM was substantially justified?
    2. Whether first-tier partners meeting the net worth requirements are eligible to receive an award for litigation costs?
    3. Whether a partner in a TEFRA partnership proceeding may receive an award for costs paid by the partnership?
    4. Whether the amount sought by FRC for litigation costs was reasonable?

    Holding

    1. No, because the construction obligations were necessary to fulfill the sales contracts, making them long-term contracts under the PCM.
    2. Yes, because first-tier partners meeting the net worth requirements of the Equal Access to Justice Act (EAJA) are eligible to receive an award.
    3. Yes, but only to the extent such costs are allocable to that partner.
    4. No, because the requested amount for litigation costs was adjusted to reflect a reasonable fee.

    Court’s Reasoning

    The court reasoned that the construction obligations under FRC’s sales agreements were necessary to fulfill the contracts, thus qualifying them as long-term contracts under IRC section 460. The IRS’s position was not substantially justified as it incorrectly focused on construction not being the primary subject matter. The court also applied the EAJA and TEFRA rules, holding that first-tier partners could receive litigation cost awards based on their allocable share in the partnership. The court adjusted the litigation costs to reflect a reasonable fee based on statutory limits and cost of living adjustments, citing relevant case law and statutory provisions.

    Practical Implications

    This decision clarifies that the PCM can be used for contracts where construction is necessary to fulfill obligations, even if not the primary focus. It impacts how similar contracts are analyzed for tax purposes. For legal practitioners, it emphasizes the importance of understanding the scope of contractual obligations when advising on tax reporting methods. The ruling on litigation costs affects how costs are allocated in partnership disputes, potentially influencing settlement strategies and the financial considerations of pursuing litigation. Subsequent cases may reference this decision when addressing the application of PCM and the allocation of litigation costs in TEFRA partnership proceedings.

  • Cameron v. Commissioner, 105 T.C. 380 (1995): Finality of Earnings and Profits Calculations for S Corporations

    Cameron v. Commissioner, 105 T. C. 380 (1995)

    Earnings and profits of a C corporation converting to an S corporation are fixed at the time of conversion and cannot be adjusted retroactively based on subsequent actual contract costs.

    Summary

    In Cameron v. Commissioner, the U. S. Tax Court ruled that the earnings and profits of Cameron Construction Co. must be calculated using year-end estimates of long-term contract costs as of the last C corporation year, without retroactive adjustments upon conversion to an S corporation. The company, which used the percentage of completion method, elected S corporation status. The court held that under IRC § 1371(c)(1), the earnings and profits were fixed at the time of conversion and could not be altered by subsequent cost information. This decision affects how S corporations calculate taxable dividends, emphasizing the finality of earnings and profits at the point of conversion.

    Facts

    Cameron Construction Co. was a C corporation that used the completed contract method for income but was required to calculate earnings and profits using the percentage of completion method. It elected to become an S corporation effective November 1, 1988. During 1989, the company distributed dividends to its shareholders, John and Caroline Cameron, and John and Teena Broadway. The shareholders argued that the company’s earnings and profits should be recalculated using actual costs incurred after the conversion, which would lower the taxable amount of the dividends.

    Procedural History

    The shareholders petitioned the U. S. Tax Court for redetermination of their federal income tax deficiencies for 1989 and 1990. The case was submitted based on a fully stipulated record. The court considered the impact of the S corporation election on the computation of earnings and profits and how to apply the percentage of completion method.

    Issue(s)

    1. Whether the company’s contemporaneous estimates of the cost of completing long-term contracts may be revised retroactively in computing earnings and profits under the percentage of completion method?
    2. Whether the company’s earnings and profits may be adjusted for taxable years to which its subchapter S election applied?

    Holding

    1. No, because the percentage of completion method does not allow for retroactive adjustments to year-end estimates of contract costs.
    2. No, because under IRC § 1371(c)(1), earnings and profits are frozen at the time of conversion to an S corporation and cannot be adjusted for subsequent years.

    Court’s Reasoning

    The court emphasized that the percentage of completion method is inherently self-correcting, as inaccuracies in cost estimates are corrected in subsequent years’ calculations. However, once the company elected S corporation status, its earnings and profits were fixed under IRC § 1371(c)(1). The court rejected the taxpayers’ argument for retroactive adjustments, citing the annual accounting principle and the necessity of finality in tax calculations. The court noted that the self-correcting mechanism of the percentage of completion method could not be used post-conversion due to the freeze on earnings and profits mandated by the S corporation election. The court also referenced general tax accounting principles and prior cases to support the non-acceptance of amended returns for retroactive adjustments.

    Practical Implications

    This decision has significant implications for corporations converting to S status. It clarifies that earnings and profits must be calculated at the time of conversion and cannot be revised based on later actual costs. This affects how dividends are taxed to shareholders and underscores the importance of accurate estimates at the point of conversion. For legal practitioners, this case serves as a reminder to thoroughly assess earnings and profits before advising clients on S corporation elections. Businesses should consider the potential tax implications of converting to an S corporation, especially if they are involved in long-term contracts. Subsequent cases have upheld this principle, further solidifying the rule that earnings and profits are fixed upon S corporation election.

  • Ansley-Sheppard-Burgess, Inc. v. Commissioner, T.C. Memo. 1995-440: When the IRS Abuses Discretion in Requiring a Change in Accounting Method

    Ansley-Sheppard-Burgess, Inc. v. Commissioner, T. C. Memo. 1995-440

    The IRS abuses its discretion by requiring a small business to change its accounting method from cash to percentage of completion without clear evidence that the cash method distorts income.

    Summary

    In Ansley-Sheppard-Burgess, Inc. v. Commissioner, the Tax Court held that the IRS abused its discretion in requiring a small construction company to switch from the cash method to the percentage of completion method of accounting. The company, a small contractor with average annual gross receipts under $5 million, had used the cash method consistently since incorporation. The court found that the cash method did not distort the company’s income and that the IRS’s change requirement was unsupported by law or fact, especially given the company’s small size and lack of inventory, which made it exempt under section 448 of the tax code.

    Facts

    Ansley-Sheppard-Burgess, Inc. , a construction company incorporated in Georgia, used the cash receipts and disbursements method for its federal tax reporting since its inception in 1980. The company did not maintain an inventory and had average annual gross receipts of approximately $2. 4 million. It was required by its bonding company and banks to prepare financial statements using the percentage of completion method. In 1993, the IRS issued a notice of deficiency asserting that the cash method did not clearly reflect the company’s income and mandated a switch to the percentage of completion method for tax year 1990, resulting in an income adjustment.

    Procedural History

    The IRS issued a notice of deficiency in May 1993, requiring Ansley-Sheppard-Burgess to change its accounting method to the percentage of completion method for tax year 1990. The company filed a petition with the Tax Court to contest this change. The Tax Court reviewed the case and ultimately ruled in favor of the petitioner, finding the IRS’s determination to be an abuse of discretion.

    Issue(s)

    1. Whether the IRS abused its discretion by requiring the petitioner to change its accounting method from the cash receipts and disbursements method to the percentage of completion method?

    Holding

    1. Yes, because the IRS’s determination was an abuse of discretion, as the petitioner’s use of the cash method did not distort its income and was permitted under section 448 of the Internal Revenue Code due to its status as a small contractor with gross receipts under $5 million.

    Court’s Reasoning

    The Tax Court’s decision hinged on several key points. First, it noted that the IRS has broad discretion under section 446(b) to determine whether a method of accounting clearly reflects income, but this discretion is not unlimited. The court referenced prior cases like Knight-Ridder Newspapers and RLC Indus. Co. , which emphasize the heavy burden on taxpayers to prove an abuse of discretion by the IRS. However, the court also recognized that the IRS cannot require a change in accounting method without clear evidence that the current method distorts income. The court cited Magnon v. Commissioner and Van Raden v. Commissioner to support the use of the cash method in the construction industry, emphasizing that mismatching of income and expenses inherent in the cash method does not necessarily constitute distortion. Furthermore, the court interpreted section 448 to allow small businesses like the petitioner to use the cash method, as Congress intended to protect small contractors from the complexities and costs of other accounting methods. The court rejected the IRS’s argument that a substantial-identity-of-results test was necessary, stating that such a test applies primarily to businesses required to maintain inventories, which the petitioner was not. The court concluded that the IRS’s determination was arbitrary and capricious, lacking a sound basis in fact or law.

    Practical Implications

    This case reinforces the principle that the IRS’s discretion to change a taxpayer’s accounting method is not absolute, particularly for small businesses. Legal practitioners should advise clients that the cash method remains viable for small contractors, especially those with gross receipts under $5 million, and that the IRS must provide clear evidence of income distortion to mandate a change. This decision may influence future cases by emphasizing the importance of the taxpayer’s size and industry norms in assessing accounting methods. Businesses should document their consistent use of accounting methods and their compliance with relevant tax code sections to challenge IRS determinations effectively. Subsequent cases, such as J. P. Sheahan Associates, Inc. v. Commissioner, have further clarified the application of accounting method rules, particularly regarding the substantial-identity-of-results test, but Ansley-Sheppard-Burgess remains a pivotal case for small contractors.

  • Basalt Rock Co. v. Commissioner, 10 T.C. 600 (1948): Method of Accounting for Excess Profits Tax

    10 T.C. 600 (1948)

    When a corporation elects to compute income from long-term contracts using the percentage of completion method for excess profits tax purposes, that method must be used for all calculations within the excess profits tax provisions, including the 80% limitation.

    Summary

    Basalt Rock Co. elected to use the percentage of completion method for reporting income from its long-term contracts for excess profits tax purposes, while regularly using the completed contract method for income tax. The Tax Court addressed whether the corporation’s surtax net income for the 80% limitation on excess profits tax should be computed using the percentage of completion or the completed contract method. The court held that the election to use the percentage of completion method applied to all aspects of the excess profits tax computation, including the 80% limitation.

    Facts

    Basalt Rock Co. was a California corporation engaged in shipbuilding and manufacturing. It regularly used the completed contract method for its long-term contracts when filing its federal income and declared value excess profits tax returns. However, when filing its excess profits tax return for 1942, the company elected to compute its income from long-term contracts using the percentage of completion method, as permitted by Section 736(b) of the Internal Revenue Code.

    Procedural History

    The Commissioner of Internal Revenue determined a deficiency in Basalt Rock’s excess profits tax liability. Basalt Rock disputed the deficiency and claimed an overpayment. All issues were settled except whether the surtax net income for the 80% limitation should be computed using the percentage of completion or the completed contract method. The Tax Court heard the case.

    Issue(s)

    Whether, for purposes of the 80% limitation provided in Section 710(a)(1)(B) of the Internal Revenue Code, Basalt Rock’s surtax net income should be computed according to the percentage of completion method or the completed contract method, given its election under Section 736(b) to report income from long-term contracts on the percentage of completion method.

    Holding

    Yes, because the election to use the percentage of completion method for long-term contracts applies to all calculations within the excess profits tax provisions, including the computation of the corporation surtax net income for the 80% limitation under Section 710(a)(1)(B).

    Court’s Reasoning

    The Tax Court reasoned that Section 736(b) specifically allows a taxpayer to elect the percentage of completion method for purposes of the excess profits tax subchapter (Subchapter E of Chapter 2). The court emphasized that the election, once made, is irrevocable and applies to all contracts. The court relied heavily on the regulatory interpretation of the statute, finding it neither unreasonable nor inconsistent with the statutory language. The court stated, “The only reasonable interpretation of the statute, in our view, requires the use of the basis elected, for every purpose of subchapter E of chapter 2.” The Court emphasized that the term “corporation surtax net income, computed under section 15” did not preclude using the percentage of completion basis, as Section 15 itself allows for different accounting methods. The Court referenced prior cases like Kimbrell’s Home Furnishings, Inc. v. Commissioner to underscore the need for consistency in applying the elected accounting method for all excess profits tax calculations. Dissenting opinions argued that the statute clearly dictates using the actual corporation surtax net income for the 80% limitation, as computed under Chapter 1, and that the regulation was an invalid expansion of the statute.

    Practical Implications

    This case clarifies that taxpayers electing a specific accounting method for long-term contracts under Section 736(b) must consistently apply that method throughout all calculations related to the excess profits tax, including limitations and credits. This decision emphasizes the importance of carefully considering the ramifications of such an election, as it affects not only the calculation of excess profits net income but also any limitations based on corporation surtax net income. Later cases would rely on this decision to enforce consistency in accounting methods within the complex framework of the excess profits tax.