Opinion

Shea Homes, Inc. v. Commissioner

142 T.C. 60
142 T.C. No. 3
2014 U.S. Tax Ct. LEXIS 4

Court: United States Tax Court
Filed: Feb 12, 2014
Status: Published
Author: Wherry
On the bench: Wherry
Cited by: 7 cases
Authority: More cited than 57.6%

permitting deferral of income from contracts where the completed qualifying dwelling units were, themselves, included in the property being sold and giving rise to the asserted taxable income

How later courts described this case

permitting deferral of income from contracts where the completed qualifying dwelling units were, themselves, included in the property being sold and giving rise to the asserted taxable income

Written by the judges who cited it.

The opinion

SHEA HOMES, INC. AND SUBSIDIARIES, ET AL., 1 PETITIONERS

v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket Nos. 29271–09, 1400–10, Filed February 12, 2014.

1401–10.

Corporation C and partnerships S and V develop large,

planned residential communities. They develop the land and

construct homes and common improvements, including amen-

ities. For the years at issue they reported income from their

contracts for the sale of homes using the completed contract

method of accounting. Under their interpretation of this

method of accounting, their contracts are complete when they

meet the use and 95% test pursuant to sec. 1.460–1(c)(3)(A),

Income Tax Regs., and incur 95% of the costs of the develop-

ment. They contend that final completion and acceptance

pursuant to sec. 1.460–1(c)(3)(B), Income Tax Regs., does not

occur (after excluding secondary items, if any, pursuant to sec.

1.460–1(c)(3)(B)(ii), Income Tax Regs.) until the last road is

paved and the final bond is released. R seeks to place C, S,

and V on his interpretation of the completed contract method.

R contends that the subject matter of the contracts of C, S,

and V consists only of the houses and the lots upon which the

houses are built. Under R’s interpretation, the contract for

each home meets the final completion and acceptance test

upon the close of escrow for the sale of each home. R also

alleges that contracts entered into and closed within the same

taxable year are not long-term contracts under I.R.C. sec. 460.

Held: The subject matter of the contracts consists of the home

and the larger development, including amenities and other

common improvements. Held, further, C, S, and V are per-

mitted to report income and losses from sales of homes in

their planned developments using their interpretation of the

completed contract method of accounting.

Gerald A. Kafka, Rita A. Cavanagh, Chad D. Nardiello,

and Sean M. Akins, for petitioners.

Melissa D. Lang, Allan E. Lang, David Rakonitz, and

Nicholas D. Doukas, for respondent.

WHERRY, Judge: These consolidated cases are before the

Court on a petition for redetermination of deficiencies in

income tax respondent determined for petitioner Shea

Homes, Inc., and Subsidiaries’ 2004 and 2005 tax years; a

1 Cases

of the following petitioners are consolidated herewith: Shea

Homes, LP, J F Shea, LP, f.k.a. J F Shea, LLC, Tax Matters Partner, dock-

et No. 1400–10; and Vistancia, LLC, Shea Homes Southwest, Inc., Tax

Matters Partner, docket No. 1401–10.

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(60) SHEA HOMES, INC. & SUBS. v. COMMISSIONER 61

petition for review of notices of final partnership administra-

tive adjustment respondent issued for the 2004, 2005, and

2006 tax years of Shea Homes, LP; and a petition for review

of notices of final partnership administrative adjustment

respondent issued for the 2004 and 2005 tax years of

Vistancia, LLC.

The ultimate issue for decision in these cases is whether

Shea Homes, Inc., and Subsidiaries, Shea Homes, LP, and

Vistancia, LLC, properly reported income and loss from the

sale of homes in their planned developments using the com-

pleted contract method of accounting provided for in section

460. 2 The resolution of this issue turns on the determination

of whether the home sale contracts include the development

amenities or are limited to the house and the lot on which

it sits.

FINDINGS OF FACT

The parties’ stipulation of facts and the accompanying

exhibits are incorporated herein by this reference.

Petitioners

Petitioner in docket No. 29271–09, Shea Homes, Inc. (SHI),

and Subsidiaries, is an affiliated group of corporations with

the common parent, SHI, organized under the laws of Dela-

ware. At all relevant times SHI maintained its principal

offices in Walnut, California. SHI used the accrual method as

its overall method of accounting for the years at issue.

The partnership in docket No. 1400–10, Shea Homes, Lim-

ited Partnership (SHLP), is a limited partnership organized

under the laws of California. J F Shea, LP, f.k.a. J F Shea,

LLC (JFLP), is the tax matters partner of SHLP. 3 At all rel-

evant times SHLP maintained its principal offices in Walnut,

2 Unless

otherwise indicated, all section references are to the Internal

Revenue Code of 1986 (Code), as amended and in effect for the taxable

year at issue, and all Rule references are to the Tax Court Rules of Prac-

tice and Procedure. All monetary amounts are rounded to the nearest dol-

lar unless otherwise noted.

3 Effective April 1, 2005, JFLP was converted from a Delaware limited

liability company, known as J F Shea, LLC, to its current form as a lim-

ited partnership.

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62 142 UNITED STATES TAX COURT REPORTS (60)

California. SHLP used the accrual method as its overall

method of accounting for the years at issue.

The partnership in docket No. 1401–10, Vistancia, LLC

(Vistancia), is a limited liability company organized under

the laws of Delaware. Shea Homes Southwest, Inc. (SHSI),

is the tax matters partner of Vistancia. At all relevant times

Vistancia maintained its principal offices in Scottsdale,

Arizona. Vistancia used the accrual method as its overall

method of accounting for the years at issue.

During the tax years at issue, SHI, SHLP, and Vistancia

deferred revenue, costs of sales, and income from the con-

tracted-for sales of homes that closed in escrow as follows:

2002 2003 2004 2005 2006

SHI:

Revenue --- --- $81,066,693 $122,237,525 ---

Cost of

sales --- --- 64,005,169 80,638,808 ---

Income $9,260,993 17,061,524 41,598,717

Vistancia:

Revenue --- --- 92,348,246 310,218,513 ---

Cost of

sales --- --- 66,561,918 212,621,241 ---

Income --- 8,835,716 25,786,328 97,597,272 ---

SHLP:

Revenue --- 289,761,283 563,962,237 944,999,695 $956,921,373

Cost of

sales --- 235,477,059 417,368,568 678,173,038 739,981,843

Income1 $182,000 54,284,224 146,593,669 266,826,659 216,939,529

1 In 2002, SHLP deferred $3,149,537 of income. It then determined that it had erro-

neously deferred $2,967,537 of that amount; and rather than file an amended return

for 2002, it included the $2,967,537 in income on the 2003 return, which respondent

accepted. The remaining $182,000 has apparently not yet been recognized. In addi-

tion, the parties stipulated that the income calculation for the 2006 year contains a

rounding error. The income calculation for the 2005 year also likely contains a round-

ing error.

For the tax years at issue, SHI, SHLP, and Vistancia

deferred some income from the sales of homes in the tax

years the contracts for those sales closed in escrow and then

recognized part of that income for Federal income tax pur-

poses in following years as follows:

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(60) SHEA HOMES, INC. & SUBS. v. COMMISSIONER 63

Year Deferred Year Amount

deferred income recognized recognized

SHI 2003 $9,260,993 2007 $9,260,993

2004 17,061,524 2007 17,061,524

2005 41,598,717 2007 41,598,717

Vistancia 2003 8,835,716 2009 8,835,716

2004 25,786,328 2009 25,786,328

2005 1 97,597,272 2009 97,597,272

SHLP 2002 3,149,537 2003 2,967,537

2003 2 54,466,226 2004 35,127,818

2005 18,234,951

2006 1,103,457

2004 3 146,593,669 2005 40,817,288

2006 101,577,422

2007 4,198,958

2005 266,826,659 2006 60,556,813

2007 48,350,567

2008 33,374,188

2009 21,215,992

2006 216,939,529 2007 32,896,005

2008 64,557,454

2009 49,310,872

2010 39,173,387

1 Paragraph 42(c) of the parties’ stipulation of facts reports the

amount deferred as $97,597,272. Paragraph 79 of the stipulation

reports the amount deferred as $97,597,273. This $1 discrepancy

may be the result of rounding.

2 This amount is derived from paragraph 79 of the parties’ stipu-

lation of facts and is in partial conflict with the $54,284,226

amount specified by paragraph 46(c) of the stipulation. This dis-

crepancy is the apparent result of the $182,000 of deferred but not

yet recognized income. See supra p. 62, table note 1.

3 Paragraph 48(c) of the parties’ stipulation of facts reports the

amount deferred as $146,593,669. Paragraph 79 of the stipulation

reports the amount deferred as $146,593,668. The $1 discrepancy

may be the result of rounding.

Deficiencies and Adjustments to Income

Respondent determined the following deficiencies with

respect to the Federal income tax of SHI:

Additional

Year Deficiency amended amount

2004 $5,971,533 $3,241,348

2005 14,559,551 ---

The additional amended amount in the above table rep-

resents the amount respondent asserted in an amendment to

his answer. Respondent asserts that this additional tax due

amount is necessary under section 481(a) to prevent its

permanent exclusion from Federal income taxation because

of respondent’s change in SHI’s method of accounting.

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64 142 UNITED STATES TAX COURT REPORTS (60)

Respondent also proposed the following adjustments to

partnership income with respect to SHLP and Vistancia:

Adjustments to Additional

Year partnership income items amended amounts

SHLP 2003 $54,284,226 $182,000

2004 111,465,850 ---

2005 266,826,659 ---

2006 216,939,529 ---

Vistancia 2004 25,786,328 8,835,716

2005 97,597,272 ---

Again, the additional amended amounts of taxable income

are the amounts respondent alleges, by way of amended

answer, are necessary under section 481(a). We also note

that the partnership adjustments to the Federal taxable

income of SHLP and Vistancia would have ultimately

resulted in additional taxable income to the partners and

may have resulted in significant additional tax due at the

partner level.

Respondent calculated the above amounts by including in

income amounts SHI, SHLP, and Vistancia deferred using

the completed contract method of accounting as reported on

schedules attached to their tax returns and as supported by

their underlying work papers. These amounts do not reflect

various computational, correlative adjustments. Petitioners,

SHI, JFLP, and SHSI, timely petitioned this Court for

review, and a trial was held in Washington, D.C.

Company Background

The Shea family has been in the home development busi-

ness for more than 40 years. The home development business

was operated through several entities, including SHI, SHLP,

and Vistancia. During the years at issue the Shea family

companies were one of the largest private homebuilders in

the United States.

Business Model

SHI, SHLP, and Vistancia are builders/developers of

planned communities, ranging in size from 100 homes to

more than 1,000 homes in Colorado, California, and Arizona.

During the years at issue they sold homes in 114 develop-

ments. For the purposes of these cases, the parties have

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(60) SHEA HOMES, INC. & SUBS. v. COMMISSIONER 65

selected eight representative developments and have agreed

that the Court’s findings of fact based on documents and

information from these sample developments will be control-

ling for all developments. 4

The eight developments are each representative of a divi-

sion. They are: (1) Trilogy at La Quinta; (2) Vistancia; (3)

Parkside at Reunion; (4) Breakers at Pointe Marin; (5) Costa

Azul; (6) Azure; (7) Country Lane; and (8) Sommerset at

Morgan Hill. SHI, SHLP, and Vistancia conducted their

home development business through divisions, organized on

the basis of the geographic locations of their developments,

except in the case of the Active Adults Division,

which was based on the type of development. These divisions

were as follows: (1) Active Adults Division; (2) Arizona Divi-

sion; (3) Colorado Division; (4) Northern California Division;

(5) Southern California Division; (6) San Diego Division; (7)

Inland Empire Division; and (8) Sacramento Division.

SHI, SHLP, and Vistancia pride themselves on providing

their customers with more than just the ‘‘bricks and sticks’’

of a home and emphasize the features and lifestyle of the

community to potential buyers. For example, at the Reunion

at Parkside community they advertised using the themes

‘‘live well, work well, play well’’ and ‘‘the pursuit of happi-

ness’’.

SHI, SHLP, and Vistancia purchased land in various

stages from completely raw to finished lots in developed

communities. Their business involved the analysis and

acquisition of land for development and the construction and

marketing of homes and the design and/or construction of

developments and homes on the land they acquired. The

costs incurred in their home construction business included,

by partial example: (1) acquisition of land; (2) financing; (3)

municipal and other regulatory approvals of entitlements; (4)

construction of infrastructure; (5) construction of amenities;

(6) construction of homes; (7) marketing; (8) bonding; (9) site

supervision and overhead; and (10) taxes. Their primary

source of revenue from the home development business was

from the sale of houses.

4 The agreement is subject to an exception where it is necessary for the

Court to make specific findings pertaining to the adjustments at issue, cor-

relative adjustments, or any other computational findings.

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66 142 UNITED STATES TAX COURT REPORTS (60)

We discuss infra the general process SHI, SHLP, and

Vistancia used in their home development business. Much of

the trial was dedicated to the details of the process, and we

by no means list every single step. Our intention is not to

discount those important steps not mentioned but to give a

general idea of how the development process worked.

Land Acquisition

The initial step in the process is to acquire land on which

to build the developments. Divisions of SHI, SHLP, and

Vistancia are responsible for identifying parcels of land as

candidates for development. After identification, the divisions

evaluate multiple factors to ascertain whether that property

constitutes a viable development opportunity. If a division

determines that the land is viable for development, it pre-

pares a Land Committee Report which summarizes the divi-

sion’s evaluation of the factors used to evaluate that parcel.

The Land Committee Report is then sent to the Land Com-

mittee, comprising senior executives, including owners, for

approval.

Design of Developments

The developments are typically designed by architects,

engineers, and consultants engaged by SHI, SHLP, and

Vistancia. The final design for the planned construction of

the developments is presented on a map or plat called a

Tract Map. The Tract Map is submitted for approval to the

county or municipality in which the development will be

located. SHI, SHLP, and Vistancia may be required, before

or after formal submission, to revise the design of the

development using input from the county or municipality.

Performance Bonds

SHI, SHLP, and Vistancia were required by State and

municipal law to post bonds to secure their performance with

respect to the completion of the common improvements in

their developments. 5 The bonds required them to complete

5 A surety bond is a promise to pay a party (the obligee) its loss up to

a certain amount (the bond amount) if a second party (the obligor) fails

to meet one or more obligations. A performance bond is a surety bond

issued by an insurance company or bank (the surety) in favor of an obligee

to guarantee satisfactory completion of a project by an obligor. In the real

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(60) SHEA HOMES, INC. & SUBS. v. COMMISSIONER 67

the obligations specified therein before the bonds are exoner-

ated. When performance bonds are required, they are posted

before or concurrent with the approval by and recording with

a governmental authority of a map or plat with respect to the

development. The amount of a performance bond depended

on the State and municipal law and the nature, extent, and

anticipated costs of the common improvements. The costs are

estimated by the obligee with the assistance of experts.

The obligor must purchase the bond by paying a premium

to the surety. The surety prices the performance bond pre-

mium according to the risk associated with the obligor, the

amount of the performance bond, and the term of the

performance bond. If an obligor fails to fulfill the conditions

of the performance bond, then the obligee may file a claim

with the surety by sending the surety a letter detailing the

failure of the obligor to perform under the conditions of the

performance bond. Upon receiving the claim from an obligee,

the surety forwards the claim to the obligor, who is required

to manage the claim process, including all associated costs.

If a surety is required to pay any of the bond amount to the

obligee, the surety is entitled to recover the amount paid

from the obligor and/or any third-party guarantor pursuant

to indemnifications the obligor generally must enter into

with respect to each surety.

The obligee must approve of the completion of the subject

matter before the performance bond will be exonerated.

Obtaining the approval of an obligee may involve negotiation

between the parties as to whether the obligor has satisfied

the terms of the performance bond. For example, municipali-

ties may require an obligor to repave roads, fix curbs, install

fire hydrants, or construct additional infrastructure common

improvements before releasing the obligor. Homeowners

associations may, as examples, require an obligor to repave

nature trails, fix steps in common areas, or improve a club-

house before releasing the obligor from a performance bond.

The obligees identified in the performance bonds of SHI,

SHLP, and Vistancia included the homeowners associations

estate development context, a performance bond is a surety bond issued by

a surety in favor of an obligee to guarantee satisfactory completion of,

among other things, common improvements with respect to a development

constructed by an obligor (the developer).

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68 142 UNITED STATES TAX COURT REPORTS (60)

formed with respect to their developments as well as the

municipalities and States in which the developments are

situated.

A performance bond may be accompanied by a bond

guaranteeing payment of labor and material costs incurred in

the development. These bonds are referred to as ‘‘labor and

material bonds’’ or ‘‘payment bonds’’. They are surety bonds

that supplement a performance bond for labor and material

costs with respect to the conditions in the performance bond.

The obligor of a labor and material bond may pay an addi-

tional premium to post the bond, or the premium may be

included in the premium price of the associated performance

bond. The amount, premium price, and process for exonera-

tion of a labor and material bond or payment bond is similar

to that used for a performance bond.

SHI, SHLP, and Vistancia posted performance bonds, labor

and material bonds, and additional surety bonds for all eight

representative developments. For Trilogy at La Quinta, SHI

posted 28 bonds ranging in amount from $24,625 to

$3,726,220 with premiums between $163 and $12,000. 6 The

obligees on these bonds were the city of La Quinta, the

County of Riverside, the California State government, and

the Trilogy at La Quinta Maintenance Association. These

bonds were exonerated between January 30, 2007, and

December 21, 2010, with one bond for $2 million still out-

standing as of the date of the trial in these cases. 7

For the Parkside at Reunion development, SHLP posted

six bonds ranging in amount from $23,592 to $3,300,000 with

premiums between $464 and $13,200. The obligees were

Commerce City and the County of Douglas. 8 Two bonds are

6 These

figures and the ones discussed below are from bond reports pro-

vided by petitioners and in evidence as stipulations and/or stipulated ex-

hibits except in the case of Vistancia. The factual and documentary record

concerning the bonds is spotty. The parties included original documents as

to some of the bonds, but in other cases we rely solely on the bond reports.

The parties did not provide a bond report for Vistancia, but they did pro-

vide a number of bond documents.

7 Likewise, the bonds noted infra as outstanding were outstanding as of

the date of the trial.

8 The bond for the benefit of Douglas County is confusing to the Court

as it is presented as used in connection with the Parkside at Reunion de-

velopment, but the Exhibit 187–P listing references Highlands Ranch.

Parkside is in Adams County, whereas Highlands Ranch is in Douglas

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(60) SHEA HOMES, INC. & SUBS. v. COMMISSIONER 69

still outstanding. The other four bonds were exonerated

between October 5, 2006, and March 19, 2009.

For Breakers at Pointe Marin, SHLP posted 23 bonds

ranging in amounts from $1,677 to $1,708,400. The bond

report does not list the premiums paid, but other exhibits

reflect a $100 premium per bond for the other earlier

Breakers at Pointe Marin surety bonds of $1,677, $1,845,

$2,348, $2,012, $3,689, and $2,348. The obligee on these

surety bonds was Pointe Marin Association, the develop-

ment’s homeowners association. Exhibits also show perform-

ance bonds ranging from $58,635 to $82,151 with premiums

ranging from $150 to $410. The obligee of these bonds was

also the homeowners association. Obligees for the remaining

bonds listed on the bond report were Novato Sanitary Dis-

trict, North Marin Water District, and the city of Novato.

As to Costa Azul, SHLP posted five bonds. SHLP posted a

performance bond in the amount of $500,000, with a pre-

mium of $2,500. The State of California was the obligee on

this bond. SHLP also posted bonds in the amounts of

$10,950, $9,816, and $7,164 with premiums of $110, $100,

and a premium amount not disclosed by the trial record,

respectively. The fifth bond was for $172,000. The record

again does not reflect the premium, but the obligee was the

County of Orange. These bonds were exonerated as early as

January 9, 2009, and as late as July 19, 2010.

For Azure, SHLP posted 22 bonds. These bonds included a

$300,000 bond with a $1,050 premium. The obligee on this

bond was the State of California. Of the remaining bonds, at

least two were surety bonds for $20,824 and $1,885 issued

with the development’s San Elijo Hills Community Home-

owners Association as the obligee. The premiums for these

bonds were $104 and $100, respectively. The remaining 19

bonds ranged in amount from $1,105 to $98,500. The

exoneration dates on all bonds ranged from January 19,

2005, to July 1, 2008.

With respect to Country Lane, SHLP posted only one bond.

This bond was for $330,657, the obligee was the State of

Arizona, and the exoneration date was November 1, 2004.

County with the County of Arapahoe and/or the City and County of Denver

in between. The explanation may involve utilities such as water or sewage

treatment or an error in the exhibit.

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70 142 UNITED STATES TAX COURT REPORTS (60)

As for Sommerset at Morgan Hill, the bond report shows

that SHLP posted five bonds. According to the report, these

bonds ranged in amount from $52,750 to $570,800. The

obligee on four of these bonds was the County of Riverside,

and the obligee on the fifth bond was the County of San

Bernardino. The report reflects that three of these bonds

were exonerated on December 7, 2007. The parties also

included an unsigned copy of a surety bond not included in

the bond report reflecting a sixth bond for $300,000 with a

premium of $1,050 and the State of California as the obligee.

Finally, for Vistancia, the parties introduced evidence of

three performance bonds. These bonds were for $134,358,

$346,971, and $235,441 with premiums of $672, $1,735, and

$1,177, respectively. The obligee on the $134,358 bond was

the city of Peoria, Maricopa County, Arizona. The obligee on

the other two was the development’s homeowners associa-

tion.

Budgeting

SHI’s, SHLP’s, and Vistancia’s operating divisions pre-

pared budgets for the direct and indirect costs relating to the

construction of developments. They prepared the budgets on

a development-wide basis by compiling a budget file, referred

to as a Tract-Property Investment Evaluator file (Tract-PIE

file). 9 They used this tool to monitor the anticipated and

actual development costs and the projected and actual rev-

enue from the sale of homes in the development. They also

updated the development’s Tract-PIE file on an annual, semi-

annual, or quarterly basis depending on the needs of the par-

ticular development.

The Tract-PIE data inputs included: incurred costs and

revenue received with respect to the development (actuals);

job cost reports containing estimated unincurred costs (job

cost); 10 sales and marketing forecasts (sales and marketing);

estimated construction costs per home model (direct construc-

9 Tract-PIE is a commercial software tool used to forecast and monitor

the costs and revenue associated with constructing a development.

10 The job cost data input is the estimated, non-home-specific construc-

tion costs, including estimated costs for the purchase of land, design of the

development, construction of infrastructure and amenity common improve-

ments, labor, fees, and property taxes.

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(60) SHEA HOMES, INC. & SUBS. v. COMMISSIONER 71

tion template); 11 estimated revenue from the sales of homes

(sale price revenue); and inflation and appreciation assump-

tions (inflation/appreciation). Respondent does not challenge

the accuracy of the construction budgets.

Estimates of revenue from home sales involved projections

of the average price of sold homes, the sales absorption rate,

the construction cycle, and price appreciation, among other

variables. SHI, SHLP, and Vistancia came up with their

anticipated revenue starting with a projection of the number

of houses they intended to build in a development and how

many different floor plans they intended to offer. The divi-

sions estimated, using experience and sometimes the help of

outside consultants, a sale price for each floor plan.

The prices per floor plan were exclusive of any discount or

premium for views, lot size, or other aesthetic draws or draw-

backs. Rather SHI, SHLP, and Vistancia estimated each pre-

mium and discount as a development-wide number; then

they divided that number by the projected number of units

to arrive at an average discount and premium per unit. SHI,

SHLP, and Vistancia used the average price per home, plus

the premium and less the discount, to come up with a gross

revenue figure and, after considering forecasted sales pace,

added on additional revenue for expected future price

increases.

Similarly, SHI, SHLP, and Vistancia generally estimated

costs on a development-wide basis, although some costs are

estimated on a per-unit basis and extrapolated to a develop-

ment-wide basis (e.g., their initial pro forma for Azure esti-

mated a permitting cost of $3,000 per house). But they could

roughly estimate costs on an average per-unit basis by

dividing the total amount of estimated costs by the estimated

number of homes to be sold.

The Land Committee Report discussed supra included an

estimated budget of that development’s revenue and

expenses. SHI, SHLP, and Vistancia also summarized esti-

11 The direct construction template consists of the estimated costs on a

per-square-foot basis to construct each home model sold in that develop-

ment.

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72 142 UNITED STATES TAX COURT REPORTS (60)

mated costs and revenues on a so-called napkin, 12 which

included information from the Land Committee. On these

reports ‘‘direct expenses’’ represented the actual ‘‘bricks and

sticks’’ costs of home construction in the development. The

parties provided Land Committee Reports and napkins for

only four of the developments.

Construction of Developments

SHI, SHLP, and Vistancia constructed their developments

in a sequence of stages consisting of: grading land; initial

construction of amenity and infrastructure common improve-

ments; construction of homes; and construction and finaliza-

tion of any remaining common improvements. The amount of

time it took to grade the land and initially construct the

amenities and common infrastructure varied with the size,

surface and subsurface condition, and nature of the develop-

ment. The grading process was particularly subject to risk

because often soil conditions under the surface differ from

what was originally anticipated. While SHI, SHLP, and

Vistancia assigned a cost and a time line to the initial

construction phase, that time and cost would vary with

conditions. It took approximately three to five months to con-

struct a single-family detached home and approximately six

to eight months to construct multifamily attached homes. For

large developments, they could perform the construction

stages in phases.

Homeowners Associations

Each development had at least one homeowners associa-

tion. These associations could include homeowners associa-

tions, condominium associations, maintenance associations,

master associations, and community associations. The struc-

ture, activities, and obligations of an association were gov-

erned by, inter alia, (i) the articles of incorporation, (ii)

bylaws, and (iii) covenants, conditions, and restrictions docu-

ments with respect to those associations.

12 The napkin is so called because it is a quick pro forma estimate, as

if one were quickly evaluating a project on a napkin.

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(60) SHEA HOMES, INC. & SUBS. v. COMMISSIONER 73

Pricing of Homes

SHI, SHLP, and Vistancia charged a single price for their

homes. This is the ‘‘total purchase price’’. They did not

charge separate prices for the home, the lot, improvements

to the lot, infrastructure and amenity common improve-

ments, financing, fees, property taxes, labor and supervision,

architectural and environmental design, bonding, or any

other costs. They could increase the price of a home by

charging a lot/homesite or elevation premium. Such a pre-

mium was an additional charge for a home on a lot with pre-

ferred qualities or a home with aesthetic, architectural, or

design upgrades to the exterior. SHI, SHLP, and Vistancia

could also increase the price of a home for additional options

or upgrades to the home. All of these charges were included

in the total price set forth in the purchase and sale agree-

ment.

Marketing

SHI, SHLP, and Vistancia used multiple forms of mar-

keting including: print (magazines, newspapers, flyers, and

pamphlets); radio; television; the Internet; billboards; and

word of mouth. For a prospective buyer visiting a develop-

ment, their on-site marketing efforts included: driving tours;

guided walking tours of a development’s amenities; models of

amenities that remain under construction; movies; and walk-

throughs of model homes presented in a community style.

SHI, SHLP, and Vistancia started their marketing process

well in advance of the opening of the community. For

example, the Active Adults Division developed a preselling

process called tsunami. This process included focus groups,

lead-generating mailers, and design shows. These design

shows, also known as charrettes, and focus groups invited

potential consumers to contribute to the design of the

community. The consumers would, before the first home was

sold, get a sense of ownership in the community. Often

participants in this presale process would be the first buyers

once the development was opened for sale.

After the presale process, the community was generally

opened for sales. At this point SHI, SHLP, and Vistancia

intended to have finished constructing the community center

and the model gallery. They thereafter continued to advertise

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74 142 UNITED STATES TAX COURT REPORTS (60)

using the tools discussed above. For example, with respect to

Parkside at Reunion they established a Web site,

reunionco.com; ran newspaper ads; and used billboards. Gen-

erally, this marketing process was geared towards selling the

community and lifestyle, not just the homes.

At Vistancia, the ‘‘marketing trail’’ began when consumers

first drove into the community. Vistancia purposefully

designed the development so that the consumer, to get to the

tour center and sales office, had to drive past all of the major

amenities. They designed the grading of the land to make

sure the water feature for the 18th hole of the golf course

was visible for the entire drive from the gatehouse. They also

oriented waterfalls and other aesthetics towards the con-

sumer to maximize visibility on the drive in. Essentially,

prospective purchasers’ views during their initial drive into

a community was intended to be a silent sales corridor.

The sales staff at Vistancia greeted the consumers by their

names, which had been radioed from the gatehouse to the

tour center. At the tour center, the staff showed the con-

sumers a short video, which emphasized the development’s

friendships, lifestyle, and community. The potential buyers

then toured the clubhouse and the golf club and all of the

various amenities. This tour could take between three and

five hours. Customers then returned to the tour center,

where Vistancia’s sales staff explained the benefits of living

in the community. They began their explanation of the bene-

fits at the macro geographical area and the proximity to La

Quinta and then moved on to the micro level of the Vistancia

community. Finally, the potential customers entered the

model gallery, which consisted of several model homes as

well as cafes and an amphitheater. Vistancia showed the

homes only at the end because the marketing approach and

product encompassed much more than the home, and it tried

to showcase features and amenities to sell ‘‘the dream’’ to set

up the sale of the home.

Financial Data Tracking

SHI, SHLP, and Vistancia used Tract-PIE software to

record, account for, and summarize incurred and budgeted

data with respect to each development. The information

Tract-PIE kept on file for each development included

cashflow receipts and disbursements, income statement, bal-

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(60) SHEA HOMES, INC. & SUBS. v. COMMISSIONER 75

ance sheet, internal rate of return, financing data, book

interest allocations, inflation projections, total units, units

closed, and projected unit closings for both incurred and

budgeted data during the duration of the development. The

Tract-PIE software tracked costs by both indirect and direct

costs. SHI, SHLP, and Vistancia updated the budgeted costs

quarterly with information provided by the divisions.

The software allowed a breakdown of direct costs into a

number of categories. The land and acquisitions category rep-

resented costs to purchase the development land. The profit

and participation agreements category represented agree-

ments in which the seller of the development land had the

opportunity to share in the profits of the development. The

forward planning category represented costs associated with

civil engineering, design, and architecture for the develop-

ment. Direct construction costs were the costs incurred in the

vertical construction of the homes, and option deposits and

option costs reflected costs incurred with respect to upgrades

buyers could select. Model upgrade costs were costs with

respect to the model homes. Commitment fees were costs

associated with financing activities. Finally, the sales tax

category represented the Arizona sales tax that jurisdiction

imposed on the sale of a home.

The indirect cost categories included property tax pay-

ments, site development/land development/common area costs

for infrastructure, and amenities within a development. The

category for amenities and golf reflected costs for a develop-

ment’s golf course(s). The permits and fees category recorded

payments to municipal and State jurisdictions to permit con-

structing of the development. A property tax payments cat-

egory reflected payments made for tax on property not yet

conveyed to third parties, either through sale or through

transfer to the homeowners associations or municipalities.

There were also indirect cost categories for rebates/credits,

indirect construction costs, management fees, and miscella-

neous costs. Petitioners received rebates and credits from

their materials suppliers if they met certain purchase quotas.

Indirect construction costs were costs associated with super-

vision, cleanup, architectural review, and other similar

activities with respect to construction. Management fees

were fees paid in developments being built as a joint venture.

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76 142 UNITED STATES TAX COURT REPORTS (60)

Miscellaneous costs consisted of any other indirect cost not

covered by the other categories.

The Tract-PIE files allowed SHI, SHLP, and Vistancia to

compare the indirect costs to the direct costs. For example,

exhibits and testimony show that for the 2005 tax year, the

indirect costs of Parkside at Reunion were approximately

27% or more of the total budgeted costs. Similar or even

larger percentages applied to other developments such as

Vistancia and Trilogy at La Quinta, where SHI, SHLP, or

Vistancia was responsible for converting raw land into a

development rather than purchasing and developing just a

portion of another developer’s project, where some indirect

costs had already been incurred and were included in land

costs.

To monitor operational performance and income tax

compliance, SHI, SHLP, and Vistancia divided the total

incurred direct and indirect costs by the total budgeted direct

and indirect costs. Their tax department made relevant

adjustments to reflect what it considered to be the require-

ments of section 460, such as capitalization computations

and tax interest analyses. If the incurred costs were equal to

or greater than 95% of the budgeted costs, then they reported

income for that tax year from homes that had closed in

escrow up to that date. If the incurred costs did not exceed

95%, then they deferred any income from homes that closed

in escrow that year.

For Federal income tax purposes during 2002 and 2003,

SHLP compared the total number of homes closed in a

development to the number projected to be closed by the end

of the development. SHI computed the 95% test by com-

paring the development’s total incurred direct and indirect

costs to the development’s total budgeted direct and indirect

costs. For the 2003 and 2004 tax years, Vistancia did not

mathematically determine whether either the 95% test or the

final completion and acceptance test had been met, the rea-

son being that Vistancia estimated there were no cir-

cumstances under which the 95% test would be satisfied

because such a small portion of the homes in the develop-

ment had been completed.

For all tax years after 2003, except as just noted, SHI,

SHLP, and Vistancia used the Tract-PIE software and

related documentation to compare the development’s

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(60) SHEA HOMES, INC. & SUBS. v. COMMISSIONER 77

incurred direct and indirect costs to the development’s total

budgeted direct and indirect costs for the purposes of deter-

mining whether to report income for Federal income tax pur-

poses under their interpretation of the completed contract

method of accounting.

Description of the Eight Representative Developments

Trilogy at La Quinta

The Trilogy at La Quinta development was a gated

community with security and landscaping features located in

Riverside County, within the city limits of La Quinta, Cali-

fornia. The Trilogy development was constructed in eight

phases, with 1,238 total lots and residences situated on

approximately 536 acres. Construction began in or about

July 2000. The Trilogy development included a 30,000-

square-foot clubhouse with a ballroom, a center for higher

learning, a studio for creative arts, a cafe, a kitchen, a

catering kitchen, a grand living room, offices, mail offices,

locker rooms, studios, an indoor pool, an outdoor pool,

cabanas, an indoor running track, a fitness center, a medita-

tion garden, and a spa. It also had outdoor walking, running

and bike paths, tennis courts, and outdoor recreation areas.

Vistancia

The Vistancia development was in Peoria, Arizona, and

included three subdivisions: Vistancia Village, Blackstone,

and Trilogy. As originally designed, the plan was to include

18 phases, situated on approximately 7,100 acres. Construc-

tion of the Vistancia development began in or about January

2002. The Vistancia development included a 3.5-mile trail

system, a restaurant, a spa, pools, a basketball gymnasium,

a multipurpose building, a tennis court, parks, open spaces

for wildlife, playgrounds, and a country club.

Parkside at Reunion

The Parkside development was in Commerce City, Colo-

rado. It was a subdivision of a larger development named

Reunion. Construction of the Reunion development began in

or about May 2001 and continued through December 2011 in

four phases, with 1,875 total lots and 1,425 total residences

on approximately 980 acres. The Reunion development

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78 142 UNITED STATES TAX COURT REPORTS (60)

included a 21,000-square-foot recreation center featuring an

indoor gymnasium, a fitness center, aerobics, meeting, and

locker rooms, an outdoor pool with interactive water features,

a 52-acre central park that includes multiuse athletic fields,

trails, playgrounds, picnic facilities, and an amphitheater, 10

miles of walking, running and biking trails, 8 acres of lakes,

150 acres of parks, and 170 acres of open space.

Breakers at Pointe Marin

The Breakers at Pointe Marin development was in Novato,

California. It was a subdivision of a larger development

called Pointe Marin. The homes in the Breakers at Pointe

Marin were constructed in 10 phases, with 106 total lots

situated on approximately 25 acres, beginning in or about

May 2004. The Pointe Marin development included walking,

running, and bike paths as well as open spaces for wildlife.

Costa Azul

The Costa Azul development was a gated community with

security features located in Newport Beach, California. This

development was a subdivision of a larger development called

Pacific Ridge. It consisted of 42 total lots, situated on

approximately 22 acres. The homes in Costa Azul were con-

structed in eight phases beginning in or about April 2004.

The development included a recreation center, tot lots, a

swimming pool, a spa, locker rooms, a park, and walking,

running, and biking trails and paths, including open spaces

for wildlife.

Azure

The Azure development was in San Marcos, California. It

was a subdivision of a larger development called San Elijo

Hills. The homes in the Azure development were constructed

in four phases beginning in or about November 2003. It con-

tained 92 total lots, situated on approximately 30 acres. The

Azure development included a park, a pet run area, a skating

area, a swimming pool, and a daycare facility.

Country Lane

The Country Lane development was in Gilbert, Arizona. It

was a subdivision of a development called Neely Commons.

The homes in the Country Lane development were con-

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(60) SHEA HOMES, INC. & SUBS. v. COMMISSIONER 79

structed in a single phase, with 193 total lots, situated on

approximately 25 acres, beginning in or about July 2002. The

Country Lane development included a park, landscaped

pedestrian areas, a soccer field, a tot lot, ramadas, and a

half-court basketball facility.

Sommerset at Morgan Hill

The Sommerset at Morgan Hill development was in

Temecula, California. It was a subdivision of a larger

development called Morgan Hill. The homes in the

Sommerset at Morgan Hill development were constructed

beginning in or about March 2004 in seven phases with 70

total lots, situated on approximately 17 acres. The develop-

ment included a community center, a clubhouse, tennis

courts, swimming pools, spas, a tot lot, and walking, running,

and biking paths.

Documentation

Purchase and Sale Agreement

SHI, SHLP, and Vistancia entered into sales contracts

with prospective homebuyers. The purchase and sale agree-

ment identified the buyer and the seller. It provided that the

buyer agreed to purchase the property and the seller agreed

to sell the property. When the buyer and the seller entered

into a contract for the purchase of a home, the buyer had to

remit an earnest money deposit. Once the contract had been

executed the parties were obligated to perform. Before the

buyer and seller could close escrow on a home, SHI, SHLP,

and Vistancia were required to either construct all common

improvement areas for the development (or phase) or post a

bond as discussed supra. Therefore, in some instances the

buyers were required to pay the full contract price before all

of the common improvements and amenities promised for

that development were completed.

Before escrow could close, SHI, SHLP, and Vistancia had

to obtain a certificate of occupancy from the local government

having jurisdiction over the home. Once the funds and the

closing documents were in escrow, and in proper order and

duly executed, the deed transferring the property to the

buyer was recorded. An average of four to six months passed

between the time the buyer and the seller entered into the

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80 142 UNITED STATES TAX COURT REPORTS (60)

contract for the purchase of a home and the time when

escrow closed. At closing, SHI, SHLP, and Vistancia had

expended all costs required to construct the dwelling unit

and the improvements to the lot on which it sat.

For the two representative developments in Arizona,

Country Lane and Vistancia, the purchase contracts and the

closing and escrow instructions included a statement dis-

closing the purchaser’s right to receive and read a copy of the

development’s public report before signing the purchase

agreement. The documents also included an initialed and

signed acknowledgment, by the purchaser(s), of the receipt of

a copy of the development’s public report and of the oppor-

tunity to read it. The purchaser(s) also signed a receipt docu-

menting that he/she acknowledged the public report, identi-

fied by a registration number and a date, and the informa-

tion contained therein, which constituted a part of the pur-

chase contract and closing and escrow instruction docu-

mentation.

For the five representative developments in California,

Trilogy at La Quinta, Breakers at Pointe Marin, Costa Azul,

Azure, and Sommerset at Morgan Hill, the purchase con-

tracts and the closing and escrow instructions included Cali-

fornia DRE Form RE614E, Receipt For Public Report Or

California Permit, as evidence of the purchasers’ receipt of

the public report. This document stated:

The Laws and Regulations of the Real Estate Commissioner require that

you as a prospective purchaser * * * be afforded an opportunity to read

the public report * * * for this subdivision before you make any written

offer to purchase * * * a subdivision interest or before any money or

other consideration toward purchase * * * of a subdivision interest is

accepted from you.

The document further admonished prospective purchasers:

‘‘DO NOT SIGN THIS RECEIPT UNTIL YOU HAVE

RECEIVED A COPY OF THE PUBLIC REPORT * * * AND

HAVE READ IT.’’ The document further required the signa-

ture(s) of the purchaser(s) confirming that he/she had read

the public report, identified by registration number and date

of issuance.

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(60) SHEA HOMES, INC. & SUBS. v. COMMISSIONER 81

Public Reports

The purpose of a public report is to disclose to a home-

buyer the rights and obligations imposed on or granted to the

homebuyer as well as the seller with respect to a certain

development.

Arizona

In Arizona the public report stated that the Department of

Real Estate requires the developer to provide each purchaser

with a copy of the public report and to obtain a signed

receipt. It noted that the purchase contract is rescindable by

the purchaser if the developer fails to obtain a public report

before offering the subdivided lots for sale or if the developer

fails to provide the purchaser with a copy of the report. The

public report also noted the designation of the portions of the

development that are common areas, specifically stating for

one of the developments that the portions that are common

areas ‘‘ARE TO BE CONVEYED TO THE COUNTY LANE

COMMUNITY ASSOCIATION, IN EACH CASE FOR THE

USE AND ENJOYMENT OF SUCH ASSOCIATION AS

MORE FULLY SET FORTH IN THE DECLARATION OF

COVENANTS, CONDITIONS AND RESTRICTIONS

APPLICABLE TO SUCH ASSOCIATION’’.

The public reports for the two Arizona developments also

cited the locations of the development maps, which identified

the developments’ common areas and improvements. The

reports indicated the dates the developer anticipated comple-

tion of the common area improvements and facilities as well

as providing assurances that the common improvements

would be completed. Specifically, for example, the Country

Lane development reports stated: ‘‘Escrows will not close

until the Town of Gilbert has issued its Occupancy Clearance

and all Subdivision improvements have been completed. A

bond has been secured to assure the completion of the land-

scaping in the common area tracts. A bond for the completion

of the additional landscaped pedestrian areas has been

secured as assurance of their completion.’’

California

The public reports for the five developments in California

stated that a purchaser(s) must acknowledge by signature

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82 142 UNITED STATES TAX COURT REPORTS (60)

that he/she has received and read the public report for the

development. The public reports stated, under a section titled

‘‘INTEREST TO BE CONVEYED’’, that each purchaser

would receive fee title to a lot, membership in the home-

owners association, and rights to use the common areas. The

public reports also provided the developers’ estimate of when

common areas and improvements would be completed and

stated that escrows would not close until either the common

areas and facilities had been completed or bonds had been

posted. However, four of the five reports also stated that

there was no assurance the project would be completed or

developed as proposed. Therefore, while the public reports

warned the purchasers that there was no assurance that the

project would be completed or developed as proposed, the

phase of the development that the public report discussed

was assured. SHI, SHLP, and Vistancia had to complete or

post bonds ensuring completion of common improvements.

The public reports for the five California developments

included a provision that before closing escrow, the developer

was required to provide the purchaser with copies of the

homeowners association articles of incorporation, including

bylaws and covenants, conditions, and restrictions and that

those documents should be read and included numerous

provisions that substantially affected the purchasers’ rights.

Covenants, Conditions, and Restrictions

The developments were governed by a declaration of cov-

enants, conditions, and restrictions (CC&Rs). The CC&Rs

were reviewed and approved by the State’s department of

real estate and local government agencies where that

development was located and, in California and Colorado,

were recorded. 13

SHI, SHLP, and Vistancia provided each purchaser, at or

before execution of a purchase agreement, with a copy of the

declaration of CC&Rs in connection with the sales of homes

in that development. These CC&Rs provided rights and

restrictions with respect to the use and enjoyment of the pur-

chased property. CC&Rs applied to the purchaser of property

13 California and Colorado require a developer to file the CC&Rs with

the clerk and recorder’s office of the county in which the development was

located.

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(60) SHEA HOMES, INC. & SUBS. v. COMMISSIONER 83

within the development and to all future interest holders of

property in the development. The CC&Rs included a legal

description of the land subject to the CC&Rs, including both

residential lots and common areas, and all of the property

within the eight representative developments was held or

conveyed subject to the terms of their respective CC&Rs. The

purchasers of each home affirmed receipt of a copy of the

CC&Rs by signing acknowledgments in the purchase and

sale agreement or other related documents.

The CC&Rs provided the authority for the homeowners

association to administer the CC&Rs and manage the

development, including the authority to assess members and

to own and maintain common improvements. Under the

CC&Rs each homeowner in the development automatically

became a member of the development’s homeowners associa-

tion and remained a member until he/she no longer held an

ownership interest. The CC&Rs also authorized the respec-

tive homeowners associations to enforce collection action,

including filing a lien and the commencement of a foreclosure

action against any member that failed to satisfy an assess-

ment. Both the homeowners associations and their individual

members could enforce the CC&Rs.

For seven of the eight representative developments, the

CC&Rs required SHI, SHLP, and Vistancia to transfer title

to the common improvements to the developments’ respective

homeowners associations. For Parkside at Reunion, the

common improvements were not conveyed to the homeowners

association. Rather, the purchasers obtained a tenancy in

common interest with all other development owners in these

common improvements. The CC&Rs specified this ownership

interest.

Maps and Plats

The public reports referred to the tract maps on file with

the local government. These tract maps represented the final

design for the planned development. Generally, SHI, SHLP,

and Vistancia prepared tentative versions of these maps

first. The tentative map dictated grading, lots, streets, parks,

easements, and other similar features. Often the local

government required some modifications and also attached

conditions and requirements before it would accept a tract

map.

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84 142 UNITED STATES TAX COURT REPORTS (60)

Approval of a final tract map often resulted in additional

conditions, such as requiring the developer to pay for

grading, curbs, gutters, sidewalk paving, streets, and utili-

ties, which met that jurisdiction’s standards. The local

governments did not just restrict conditions to the areas

within the developments themselves. They could also condi-

tion the approval upon widening arterial roads at the bound-

aries of the developments, the building of schools, or

installing offsite traffic lights. SHI, SHLP, and Vistancia

could negotiate with respect to the scope, standards, and

nature of the conditions to some degree, but the govern-

mental authority retained the ultimate approval control over

the maps. During the entitlement process, SHI, SHLP, and

Vistancia often employed consultants. The governments also

sometimes employed consultants in this process, and on occa-

sion, SHI, SHLP, and Vistancia would cover the cost of these

government consultants.

SHI, SHLP, and Vistancia would also enter into agree-

ments with the local governmental agencies. SHI, SHLP, and

Vistancia had two options. They could build everything

required by the map, or alternatively, they could enter into

a subdivision improvement agreement with the governmental

authority. These agreements required them to post bonds for

improvements not yet built. If all of these steps were satis-

factorily completed, then the governmental authority was

obligated to record the map.

OPINION

I. Burden of Proof

Generally, the Commissioner’s determination of a tax-

payer’s liability for an income tax deficiency is presumed cor-

rect, and the taxpayer bears the burden of proving that the

determination is improper. See Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933). But if a taxpayer’s

method of accounting does not clearly reflect income, section

446(b) allows the Commissioner to change the taxpayer’s

method of accounting to one that does clearly reflect income.

The Commissioner is granted broad discretion in determining

whether an accounting method clearly reflects income, and

that determination is entitled to more than the usual

presumption of correctness. Commissioner v. Hansen, 360

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(60) SHEA HOMES, INC. & SUBS. v. COMMISSIONER 85

U.S. 446, 467 (1959); RECO Indus., Inc. v. Commissioner, 83

T.C. 912, 920 (1984). The question of whether a particular

accounting method clearly reflects income is a factual ques-

tion. Sam W. Emerson Co. v. Commissioner, 37 T.C. 1063,

1067 (1962).

To prevail, the taxpayer must establish that the Commis-

sioner abused his discretion in changing the method of

accounting. Prabel v. Commissioner, 91 T.C. 1101, 1112

(1988), aff ’d, 882 F.2d 820 (3d Cir. 1989). But the Commis-

sioner may not change a taxpayer’s method of accounting

from an incorrect method to another incorrect method. Id.

Nor may the Commissioner change a taxpayer’s method of

accounting ‘‘[w]here a taxpayer’s method of accounting is

clearly an acceptable method’’ and clearly reflects income. Id.

On brief petitioners renewed pretrial motions to shift the

burden of proof to respondent. Petitioners contend that

respondent’s determinations are excessive and arbitrary and

thus justify the burden shift. See Estate of Mitchell v.

Commissioner, 250 F.3d 696, 702 (9th Cir. 2001), aff ’g in

part, vacating in part and remanding T.C. Memo. 1997–461.

Specifically, petitioners allege, citing Golden State Litho v.

Commissioner, T.C. Memo. 1998–184, that respondent has

not identified the correct method of accounting on which he

seeks to place SHI, SHLP, and Vistancia. We disagree.

Respondent is seeking to place SHI, SHLP, and Vistancia on

his interpretation of the completed contract method, dis-

cussed in more detail below. Thus the burden of proof does

not shift in these cases.

II. Legal Framework

A. Long-Term Contracts Generally

Section 460 governs how taxpayers report income from

long-term contracts. It generally provides that taxpayers who

receive income from long-term contracts must account for

that income through the percentage of completion method.

Sec. 460(a). This method essentially requires a taxpayer to

recognize income and expenses throughout the duration of a

contract. Sec. 460(b); Tutor-Saliba Corp. v. Commissioner,

115 T.C. 1, 4 (2000). But, by an amendment, the statute

excepts, inter alia, home construction contracts. Sec.

460(e)(1)(A), (6)(A) (as amended by the Technical and Mis-

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86 142 UNITED STATES TAX COURT REPORTS (60)

cellaneous Revenue Act of 1988, Pub. L. No. 100–647, sec.

5041(b)(1), 102 Stat. at 3673).

Section 460(f)(1) defines a long-term contract as ‘‘any con-

tract for the manufacture, building, installation, or construc-

tion of property if such contract is not completed within the

taxable year in which such contract is entered into.’’ The

statute does not define completion, which is to be determined

on a contract-by-contract basis, sec. 1.460–1(f), Income Tax

Regs., but the regulations provide that a contract is com-

pleted when it first meets one of two tests, sec. 1.460–

1(c)(3)(i), Income Tax Regs. These tests are commonly known

as the use and 95% completion test, and the final completion

and acceptance test.

Under the first test, the contract is completed upon ‘‘[u]se

of the subject matter of the contract by the customer for its

intended purpose (other than for testing) and at least 95 per-

cent of the total allocable contract costs attributable to the

subject matter have been incurred by the taxpayer’’. Sec.

1.460–1(c)(3)(i)(A), Income Tax Regs. Under the second test,

the contract is completed upon ‘‘[f]inal completion and accept-

ance of the subject matter of the contract.’’ Sec. 1.460–

1(c)(3)(i)(B), Income Tax Regs. As for this latter test, ‘‘to

determine whether final completion and acceptance of the

subject matter of a contract have occurred, a taxpayer must

consider all relevant facts and circumstances.’’ Sec. 1.460–

1(c)(3)(iv), Income Tax Regs.

A further wrinkle to determining when a taxpayer com-

pletes a contract is the role of secondary items. Taxpayers

are to apply the tests to determine when a contract is com-

pleted under the completed contract method ‘‘without regard

to whether one or more secondary items have been used or

finally completed and accepted.’’ Sec. 1.460–1(c)(3)(ii), Income

Tax Regs. In applying the 95% completion test, taxpayers

‘‘must separate the portion of the gross contract price and the

allocable contract costs attributable to the incomplete sec-

ondary item(s) from the completed contract’’. Id.

B. Home Construction Contracts

A taxpayer may account for income from home construction

contracts under the completed contract method. Sec. 460(e).

That is because section 460(e) provides that the percentage

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(60) SHEA HOMES, INC. & SUBS. v. COMMISSIONER 87

of completion method will not apply to ‘‘any home construc-

tion contract’’. 14 A ‘‘home construction contract’’ is

any construction contract if 80 percent of the estimated total contract

costs (as of the close of the taxable year in which the contract was

entered into) are reasonably expected to be attributable to activities

referred to in paragraph (4) with respect to—

(i) dwelling units * * * contained in buildings containing 4 or fewer

dwelling units * * *, and

(ii) improvements to real property directly related to such dwelling

units and located on the site of such dwelling units.

[Sec. 460(e)(6)(A).]

The ‘‘activities referred to in paragraph (4)’’ are ‘‘building,

construction, reconstruction, or rehabilitation of, or the

installation of any integral component to, or improvements

of, real property.’’ Sec. 460(e)(4).

As the statute is written and depending on the meaning of

the word ‘‘site’’, taxpayers such as SHI, SHLP, and Vistancia

can have trouble meeting the 80% requirement of section

460(e)(6)(A). This occurs because a significant portion of the

contract costs may be attributable to items not ‘‘located on

the site of such dwelling units’’, such as development infra-

structure. The regulations, however, instruct a taxpayer to

‘‘include[] in the cost of the dwelling units their allocable

share of the cost that the taxpayer reasonably expects to

incur for any common improvements (e.g., sewers, roads,

clubhouses) that benefit the dwelling units and that the tax-

payer is contractually obligated, or required by law, to con-

struct within the tract or tracts of land that contain the

dwelling units.’’ Sec. 1.460–3(b)(2)(iii), Income Tax Regs.

Thus, at least for the purpose of determining whether the

contract qualifies as a home construction contract under sec-

tion 460(e), the taxpayer includes, for the 80% test, costs

attributable to common improvements in the manner dic-

tated by the regulations. Petitioners and respondent dis-

agree, however, as to whether this regulation affects the

tests in section 1.460–1(c)(3)(A) and (B), Income Tax Regs.,

14 Sec. 460(e) also contains an exception for certain other construction

contracts provided that the taxpayer meets a gross receipts test and antici-

pates the contract will be completed within two years of contract com-

mencement. Sec. 460(e)(1)(B). This section also gives a more generous per-

centage of completion method of accounting for residential construction

contracts which are not home construction contracts. Sec. 460(e)(5).

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88 142 UNITED STATES TAX COURT REPORTS (60)

that determine when the taxpayer completes the contract for

the purposes of deciding whether it is a long-term contract.

III. Analysis

We must decide whether SHI, SHLP, and Vistancia prop-

erly reported their income from the sales of homes in their

developments using the completed contract method.

Respondent contends that only the contracts that closed in

tax years different from the taxable years they were entered

into qualify as long-term contracts. Under respondent’s

interpretation of the completed contract method, SHI, SHLP,

and Vistancia must report income from these long-term con-

tracts for the years in which the contracts closed in escrow.

Respondent takes this position because, in his view, the sub-

ject matter of the contract is the home and the lot upon

which it sits. Consequently, each contract is completed,

within the meaning of section 460, in the year in which

escrow closes. That year is when respondent contends final

completion and acceptance occurs. 15 For the other contracts,

respondent would require SHI, SHLP, and Vistancia to

account for the income under their normal method of

accounting.

Petitioners are of the opinion that the subject matter of the

contracts is broader and encompasses the entire development

or, in some instances of larger developments, the develop-

ment phase of which the home is a part. In support, peti-

tioners contend that a contract comprises all documents pro-

vided to the buyer, any documents expressly referenced

therein or incorporated therein by law, and easements,

restrictions, and other documents recorded as encumbrances

on a home purchaser’s title. Petitioners assert that these

documents collectively set forth the rights and obligations of

the buyer and seller. Therefore, they contend that, other

15 It

has been 25 years since sec. 460(e)(1)(A) and (6)(A) was enacted by

the Technical and Miscellaneous Revenue Act of 1988, Pub. L. No. 100–

647, sec. 5041, 102 Stat. at 3673, and apparently development builders,

such as SHI, SHLP, and Vistancia, may have used this method since 1988.

The earliest tax year at issue in these cases is 2003. That delay in enforce-

ment is immaterial to our consideration as the Commissioner is not bound

by his failure to enforce the law in an earlier year. United States v. Woods,

571 U.S. ll, ll, 134 S. Ct. 557, 567 n.5 (2013); Coors v. Commissioner,

60 T.C. 368, 395 (1973), aff ’d, 519 F.2d 1280 (10th Cir. 1975).

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(60) SHEA HOMES, INC. & SUBS. v. COMMISSIONER 89

than secondary items if any, the final completion and accept-

ance does not occur until, as to the phase or the develop-

ment, the final road is paved and the final bond is released.

Under their interpretation, the use and 95% completion test

is met first when SHI, SHLP, and Vistancia incur 95% of the

phase’s or development’s costs. Petitioners contend that

because the 80% test for a home construction contract

includes the allocable share of the costs of common improve-

ments, the 95% test also must include these costs.

Respondent also urges an alternative theory. According to

this theory, if we hold that the subject matter of the con-

tracts is broader than the house and the lot, we must apply

the 95% completion test without regard to the costs attrib-

utable to common improvements because they are secondary

items. Petitioners, however, contend that these common

improvements are part of the primary subject matter of the

contract, not secondary items, and that they may include

such allocable costs in applying the 95% test.

The initial question is what documents are part of the con-

tracts. Under respondent’s interpretation, the subject matter

of the contracts is the lot and the house which the buyer(s)

purchase. To support this contention, respondent points to

the purchase and sale agreement as being the sole contract

document. He urges us to find that State law and the

wording of the contract necessarily restrict the contract to

only this document. Petitioners, however, contend that the

scope of the contracts exceeds the mere ‘‘bricks and sticks’’

and encompasses the development as a whole. In this vein,

petitioners assert that, for the purposes of section 460, the

contract consists of the purchase and sale agreements as well

as all documents referenced or incorporated therein. This

would encompass public reports, CC&Rs, publicly recorded

plats and maps, public resolutions or conditions of approval,

and homeowners association documents.

A. What Constitutes the Contract

1. Integration Clauses

Respondent claims that because each of the respective pur-

chase and sale agreements contains an integration clause,

the purchase and sale agreements constitute the entire con-

tract. Each purchase and sale agreement states that the

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90 142 UNITED STATES TAX COURT REPORTS (60)

agreement is the sole and entire agreement between the

buyer and the seller. Courts have given integration clauses

significant weight when interpreting contracts. See, e.g.,

Betaco, Inc. v. Cessna Aircraft Co., 103 F.3d 1281, 1283 (7th

Cir. 1996). California caselaw explains that ‘‘ ‘[t]he crucial

issue in determining whether there has been an integration

is whether the parties intended their writing to serve as the

exclusive embodiment of their agreement.’ ’’ Grey v. Am.

Mgmt. Servs., 139 Cal. Rptr. 3d 210, 213 (Ct. App. 2012)

(quoting Masterson v. Sine, 65 Cal. Rptr. 545, 547 (1968)). An

Arizona court explained: ‘‘A completely integrated contract is

a contract adopted by the parties as a complete and exclusive

statement of the terms of the contract.’’ Anderson v. Preferred

Stock Food Mkts., Inc., 854 P.2d 1194, 1197 (Ariz. Ct. App.

1993).

While we agree with respondent that the purchase and

sale agreements do contain integration clauses, we do not

conclude that the purchase and sale agreement alone serves

as the exclusive embodiment of the entire agreement between

the parties. Buyers of homes from SHI, SHLP, and Vistancia

are consciously purchasing more than the ‘‘bricks and sticks’’

of the home. The purchase and sale agreement specifically

includes a checklist ensuring that the purchaser receives the