Thursday, December 20, 2012

Summerlin, Las Vegas and Not Paying Taxes Until 2039

Let me ask you a question, and then we will discuss how taxpayers and the IRS get into high-stakes battles.

Our topic today will be “home construction.” Let’s say that there is a contractor. He buys the land, grades and prepares the dirt, and sends over employees to frame, roof, wrap and finish a house.  Would we say that he is a “home construction contractor?” Yes, we would.

Let’s change this up. Say that he still buys and preps the land, but he sends over subcontractors rather than employees. Is he still a home construction contractor? Yes, we would still consider him as such.

Switch the focus to the subcontractor. Would you consider the roofer to be a home construction contractor? If one allows the terms contractor and subcontractor to be interchangeable for this purpose, then we would say yes. The overall contract is a home construction contract, so arguably any division of such contract would also be a home construction contract. Any slice of a red velvet cake is still cake.

One more. Let’s say that a third party purchases and rezones the land, clears and grades, installs water and sewer lines, builds roads and installs landscaping. He then sells individual lots to homebuilders. What we have described is commonly called a “developer.” Would we consider the developer to be a home construction contractor?

Thus begins the tax issues of Howard Hughes Corporation and its Summerlin development in Las Vegas. This thing is massive, covering almost 35 square miles on the west side of the city.  The development covers an area approximately half the size of the District of Columbia. Summerlin does not expect to sell-out its lots until 2039. Hopefully I will have been long retired and be dipping my feet in an ocean somewhere while enjoying an afternoon mojito.

There are two general tax accounting methods for contractors. One is called the percentage-of-completion method, and the second is called the completed-contract method.

·         Under the percentage-of-completion, one recognizes income as the work progresses. Say that a contract with $5 million estimated profit is 40% complete. The taxpayer reports $2 million in profit ($5 million times 40%) to the IRS. The IRS likes this method.

·         Under the completed-contract, one does not report any income to the IRS until the job is done. In the above example, the taxpayer reports -0- profit, as the job is only 40% complete. The IRS does not like this method as much.

The IRS starts by saying that every contractor must use percentage-of-completion, but it allows a few exceptions to use completed-contract. One exception for completed-contract is for a home construction contract.

Ah, you already see where we are going with this, don’t you?

Howard Hughes Corporation is arguing that it can use the completed-contract because it is a home construction contractor. They are telling the IRS “see you in 2039.” 

The IRS is having none of this. They argue that Howard Hughes Corporation is a home construction contractor the same way The Phantom Menace was a watchable Stars Wars movie. That means that Howard Hughes Corporation defaults to the percentage-of-completion method. The IRS wants its taxes – plus interest and penalties, of course.

Each side has an argument. For example, in Foothill Ranch Company Partnership the IRS conceded that a contract for the sale of land by a developer was a long-term construction contract. In a Field Service Advise dated 5/8/97, the IRS stated that contracts for the sale of land requiring the seller to provide infrastructure or common improvements are construction contracts.

Rest assured that Howard Hughes Corporation has tax advisors who know this.

The IRS in turn determined in TAM 200552012 that a land development company selling lots through related entities did not qualify for completed contract, as the company did not actually build dwelling units. The IRS parsed words in a Code section with the cutting skills of Iron Chef Morimoto, noting that the statute uses the word “and” rather than the word “or.”

            Sigh. Can you believe what I do for a living?

The real estate, especially the development, industry is closely watching the resolution of this case. This is big-bucks. That said, does it make you uncomfortable to take an accounting method – by itself non-controversial – and stretch it to Dali-like and surrealist proportions? This is how tax law too often gets made.

I anticipate that the IRS will assert an argument involving contract aggregation and division. Once the land is implicated with further construction activity, the contracts (land and construction) will be aggregated. The ultimate sale (in our case, the home) will accelerate tax recognition on any underlying contract (in this case, the land). Might be a nightmare for accountants to trace all this, but it makes more sense than Howard Hughes Corporation delaying paying taxes on the sale of Summerlin lots until 2039.

No comments:

Post a Comment