Real Estate Group Newsletter – Spring 2019
Adam M. Levine
IRS Targets Large Land Developers
ADAM M. LEVINE, CPA, CFP
The IRS Large Business and International (LB&I) Division is currently pursuing a “compliance campaign” against large land developers of residential communities for improper use of the more taxpayer-friendly completed contract method (CCM) of accounting. The IRS believes that some developers are deferring profits under the CCM that should be recognized — and taxed — earlier.
For federal income tax purposes, long-term contracts are those that span a year-end. For example, if you enter into a contract on December 29, but do not complete work until January 20, you have a long-term contract.
The CCM allows developers to defer the recognition of taxable income and expense until the year a long-term construction contract is completed and accepted by the customer. That way, the profit is not taxed until the year the project is completed.
The alternative way to account for construction contracts is the percentage of completion method (PCM). Under the PCM, taxable income is recognized over the life of the contract based on the percentage of total costs incurred to date. For example, if a contract is 30% complete at the end of the taxable year, you would have to include 30% of the projected profit in taxable income by the end of that year.
Developers generally prefer the CCM for income tax purposes, because it is simpler and allows income to be recognized later than under the PCM. By electing to use the CCM, developers potentially could defer recognizing millions of dollars of income for tax purposes.
The CCM is permitted for:
Home Construction Contracts. These are contracts for work on buildings that have four or fewer dwelling units. At least 80% of the estimated total contract costs must be for the construction, improvement or rehabilitation of these units. Contracts to build apartment buildings with more than four units would not be home construction contracts. If a contract is not a home construction contract, the IRS classifies it as a general construction contract.
Small Contractors. Small contractors may be eligible to use the CCM for general construction contracts if:
- The contract will be completed within two years; and
- The contractor’s average annual gross receipts do not exceed $25 million for the three taxable years preceding the taxable year the contract is entered into.
The Tax Cuts and Jobs Act (TCJA) increased the gross receipts threshold for using the CCM for general construction contracts from $10 million to $25 million for taxable years beginning after 2017. Therefore, more developers and subcontractors may be eligible for the CCM, starting in 2018.
How does your firm account for construction contracts? Proactive measures can help reduce your odds of a costly audit. If you use the CCM, review contracts for compliance with the liberalized eligibility requirements under today’s tax law.
If you discover you are impermissibly using the CCM, determine the appropriate corrective action, such as amending a tax return or changing accounting methods. Then determine the tax implications of making the change to the proper method, and adjust your tax planning accordingly.
Time for a Change?
The IRS considers the timing of income recognition on long-term contracts a “method of accounting.” An examiner who determines that a developer is not permitted to use the CCM will initiate an “involuntary” change in accounting method.
But those affected need not wait for the IRS to take action. A developer that wants to change to or from the CCM also can apply for a change in accounting method. A voluntary change in accounting method must be made on a cutoff basis, meaning it will apply to contracts entered into on or after the first day of the year of the change.
A voluntary change will not necessarily prevent the IRS from investigating the issue in previous taxable years. However, the IRS has indicated that taxpayers that voluntarily correct their accounting methods generally will be protected from examination of the issue for years the taxpayer was not yet under audit.
The campaign shows that the IRS takes the CCM issue seriously. A “wait-and-see” approach could make your company vulnerable to an audit that could be costly. Set up a meeting with your tax advisor as soon as possible to discuss whether you are in compliance with the rules — and whether you might be one of the lucky contractors that are able to switch to the CCM method under the TCJA’s liberalized eligibility requirements.
For more information, contact Adam Levine at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.
What Not to Do in Like-Kind Exchanges
The Internal Revenue Code has long allowed taxpayers to use like-kind exchanges to defer taxable gains. However, this does not necessarily mean a like-kind exchange will go unchallenged by the IRS. This article summarizes a recent case in which the agency and two federal courts found a company’s property transactions more akin to loans than like-kind exchanges. In addition, it also briefly notes why appraisers must be allowed to reach their conclusions independently.
Like-Kind Exchange Options
Under IRC Section 1031, as recently amended by the Tax Cuts and Jobs Act, taxpayers can exchange business or investment real property (the relinquished property) for business or investment real property of a like kind (the replacement property) without recognizing any gain or loss until the disposition or liquidation of the replacement property. The most basic such exchange is the simultaneous swap of one property for another.
Sec. 1031 also allows a deferred, or “forward,” exchange where you transfer the relinquished property before acquiring a replacement property. And, in a reverse exchange, the replacement property is acquired and “parked” with an exchange accommodation titleholder before you transfer the relinquished property.
Like-kind exchanges are reported on Form 8824, Like-Kind Exchanges.
The Taxpayer’s Exchange Attempt
Generally, IRS rules state that gains from the sale or exchange of property must be recognized in the year they are realized, but they allow an exception for like-kind exchanges. However, to claim this exception, you must acquire a genuine ownership interest in the replacement property. Ownership for tax purposes is not determined by legal title. Rather, you must bear the “benefits and burdens” of property ownership. This was the primary issue in Exelon Corp. v. Comm’r, whether the taxpayer, an energy company, ever acquired genuine ownership of several power plants.
The taxpayer sold its fossil-fuel power plants for $4.8 billion, over $2 billion more than expected. Facing a hefty tax bill due to the gain it realized on the sales, the taxpayer entered into several sale-and-leaseback transactions. In each, it leased an out-of-state power plant from a tax-exempt entity for a period longer than the plant’s estimated useful life, prepaying the rent upfront.
The taxpayer then immediately leased the plant back to the entity for a shorter sublease term. It also provided the entity a multimillion-dollar “accommodation fee” and a fully funded purchase option at the end of the sublease. The energy company characterized these transactions as like-kind exchanges for tax purposes.
The IRS and Courts Disagree
The IRS disallowed the tax benefits the taxpayer claimed from the transactions and determined the company was liable for an income tax deficiency of about $437 million. The U.S. Tax Court agreed with the IRS, finding the transactions did not transfer to the taxpayer a genuine ownership interest in the out-of-state plants. Similar to the IRS, the court found the transactions most closely resembled loans to the tax-exempt entities. Thus, the taxpayer was not entitled to like-kind exchange treatment or the deductions it claimed as lessor of the plants for depreciation, interest and transaction costs.
On appeal, the U.S. Court of Appeals for the Seventh Circuit noted that the subleases were “net leases,” meaning they allocated all of the costs and risks associated with the plants to the sublessees. That, along with each transaction’s defeasance structure and the circular flow of money, led to “the inescapable conclusion” that the energy company faced no significant risk indicative of genuine ownership during the terms of the subleases.
The court dismissed the taxpayer’s argument that it bore the “real risk” and that the sublessees would not exercise their purchase options. According to the court, evidence in the case made clear that all of the parties to the transactions fully intended and expected the sublessees to exercise the options at the end of the sublease terms.
Penalties Highlight Importance of Appraiser Independence
In addition, the court, in Exelon Corp. v. Comm’r, also affirmed the imposition of an $87 million penalty for the taxpayer’s underpayment of taxes. Its explanation demonstrates why appraisers must be allowed to reach their conclusions independently.
The taxpayer argued that it should not be subject to the penalty because it had relied on the advice of its legal counsel. Simply relying on a professional does not necessarily relieve a taxpayer of penalties, though the reliance must have been reasonable. Here, the taxpayer’s counsel supplied the appraiser with the wording of the conclusions it expected to see in the final appraisal reports. The U.S. Court of Appeals for the Seventh Circuit found that this tainted the appraisals and the taxpayer knew, or should have known, it was unreasonable to rely on legal advice based on the tainted property appraisals.
The taxpayer asserted that it had no way of knowing the appraisals were tainted in such a way. The court, however, found extensive evidence that the taxpayer knew its counsel was providing the appraiser with the desired conclusions.
Like-kind exchanges are a valuable tax tool, but they are not always as straightforward as they might seem. Consult with your financial advisor and attorneys to structure transactions that withstand IRS and judicial scrutiny.
For more information, contact Kenny Lau at 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.
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