Comment on FR Doc # E8-17830

Comments on Proposed Regulations under Section 460 Internal Revenue Bulletin: 2008-39 September 29, 2008 Provisions Related to Definitions of Terms Proposed Reg. 1.460-3(b)(1)(ii) Clarification needed for definition of the term “site” The term “site” should be clarified, perhaps just by example, rather than by definition. Much of the current misunderstanding and perhaps future controversy could be mitigated by an example of what is the construction “site” for the HCC. The Service has previously viewed the ‘site’ as less area than many taxpayers have viewed the term. Is the “site” the individual home lot, or is the “site” the subdivision, or the construction phase? In PLR 8046014, the term “site” referred to an underground mine. In PLR 7838080 the term “site” referred to several acres. In PLR 9417040 the term “site” referred to an entire wind farm, which was probably several acres. In PLR 9508029 the term “site” referred to a medical campus. In PLR 9526033 the same term referred to the space occupied by several residential buildings. The term “site” was a nuclear power plant area in PLR 9651028; it was the space occupied by a hospital in PLR 200049022; it was a battlefield in PLR 200208019; it was a mixed use facility and parking lot in PLR 200211052; and it was 14.5 acres in PLR 200222030. With such a wide variety of sizes and types of “sites” in prior IRS documents, it could be confusing in applying the proposed Regulations. The “site” question may not be solved by the common improvement provision of the proposed Regulations. Common improvements may not encompass typical situations, such as the homeowner who buys two lots, one for the house and the adjoining lot for the garden, garage, or tennis courts. The adjoining lot improvements would not be a dwelling unit, and it would not be common improvements, but the land improvements would surely be considered part of the HCC in an economic sense. The second lot improvements appear to be outside the current definition of the dwelling unit lot and the common improvements. This comment is to suggest that all adjoining lots and land that are used for land improvements that are related to the home also come within the definition of the home for the proposed Regulations. Proposed Reg. 1.460-3(b)(2)(ii) Town house, row house, condominium terminology needs clarification A “town house” and a “row house” are descriptions of structures. A “condominium” is a type of ownership of a portion of a total structure. Structures could be of the row house type, with the ownership of the individual dwelling units either fee simple or in condominium ownership. Additionally, condominium units could be of many varieties, including a single structure with dozens of units in a high-rise configuration. Many taxpayers are interpreting the proposed Regulations to include all single family dwelling units, commonly called condos, no matter what the structural configuration, into the definition of a home, for the HCC exception to IRC 460. However the Background and Explanation to the Provisions in Reg-120844-07 may not in fact give that expanded definition – “In certain circumstances, the terms condominium and townhouse are used interchangeably to describe similar structures.” This terminology does not appear to be as expansive as most taxpayers are interpreting the proposed Regulations, but only allowing for different types of ownership to come within the structural definitions of townhouses for purposes of IRC 460(e)(6)(A). To allow the individual dwelling units of a high rise structure with dozens of such individual condominium units would make the proposed Regulations contrary to the Code provision of the 4 or fewer dwelling units of IRC 460(e)(6(A)(i). While most taxpayers would like to have the definition expanded to include the commonly used terminology of a condominium, no matter what the structural configuration, clarification of the intent of the Proposed Regulations would be helpful if it is not in fact meant to encompass condominium dwelling units in structures of more than 4 dwelling units if they are configured differently than town houses or row houses. Proposed Reg. 1.460-4(c)(1) Permissible methods for exempt contracts The Proposed Regulations insert the phrase “the accrual method” into the present Regulations. This comment takes exception to the word “the” as used in the proposed Regulations as well as the similar usage in the Background and Explanation of the Provisions. IRC 446(c)(2) specifically lists “an accrual method” as a permissible method of accounting, which indicates that there could be more than one accrual method, as in fact there are, rather than just one accrual method, which would be called “the” accrual method at IRC 446(c)(2) rather than “an” accrual method. In the construction industry, the use of a billings accrual method is common, as well as an accrual method which excludes retainage. Hamilton Industries, 97 T.C. 120, affirmed the accrual acceptance method for that company’s long-term contracts. Reference to a single accrual method by the term “the” may be misleading to taxpayers. The proposed Regulations should be changed to “an accrual method.” Provisions Related to Accounting Method Changes Regarding guidance to taxpayers with long-term contracts under Section 460(f) regarding certain changes in method of accounting for long-term contracts Included in IRB 2008-39 "Currently, the regulations under section 460 provide that a taxpayer that uses the percentage-of-completion method (PCM), the exempt-contract percentage-of- completion method (EPCM), or elects the 10-percent method or special alternative minimum taxable income (AMTI) method, or that adopts or elects a cost allocation method of accounting (or changes to another method of accounting with the Commissioner's consent) must apply the method(s) consistently for all similarly classified contracts until the taxpayer obtains the Commissioner's consent under section 446 to change to another method of accounting. The regulations further provide that a taxpayer-initiated change in method of accounting will be permitted only on a cut-off basis (that is, for contracts entered into on or after the year of change), and thus, a section 481(a) adjustment will not be permitted nor required. The proposed regulations continue this cut-off method of implementation but only for taxpayer-initiated changes from a permissible PCM method to another permissible PCM method for long-term contracts for which PCM is required and for taxpayer-initiated changes from a cost allocation method of accounting that complies with the cost allocation rules of Reg. Sec. 1.460-5 to another cost allocation method of accounting that complies with the cost allocation rules of Reg. Sec. 1.460-5. Under the proposed regulations all other taxpayer-initiated changes in method of accounting under section 460 will be made with a section 481(a) adjustment." The proposed regulations also provide that in determining the hypothetical underpayment or overpayment of tax for any year as part of the look-back computation, amounts reported as section 481(a) adjustments shall generally be taken into account in the tax year or years that they are reported. Clarifications requested 1) That nothing in these regulations regarding the Section 481(a) adjustment would alter the timing of recognition currently permitted under Revenue Procedure 2002-9 and Revenue Procedure 2002-19 relative to positive and negative Section 481(a) adjustments. 2) That the period of such 481(a) adjustment may extend beyond the year in which the contract is completed and that acceleration of such 481(a) adjustment is only required for purposes of determining the hypothetical over or under-reporting of income for the look-back calculation. Requested changes 1) It is requested that the provisions related to changes of accounting methods for long-term contract methods be made uniform to require the use of a Section 481(a) adjustment. The proposed regulations are currently not uniform in their application. The proposed regulations continue the current use of a cut-off method of implementation but only for taxpayer-initiated changes from a permissible PCM method to another permissible PCM method for contracts for which PCM is required and for taxpayer-initiated changes in methods of cost allocation from one method that complies under Reg. Sec. 1.460-5 to another method that complies under Reg. Sec. 1.460-5. All other changes are implemented using a Section 481 (a) adjustment. It is agreed that the use of a Section 481(a) adjustment to implement accounting method changes for contractors is generally a better method than using a cut-off implementation in order to avoid the large fluctuations in income that can result in the year of change due to recognizing income from previous contracts on the old method of accounting and recognizing income on new contracts under the new method of accounting. This often occurs, for example, on a change from completed contract method to percentage-of-completion method. Such fluctuations can unnecessarily result in hardship to taxpayers, for example, because of graduated tax brackets and rules regarding creation and application of net operating losses. It is unclear why the proposed regulations use a cut-off method for some changes and a Section 481(a) adjustment for others. It could be that the changes identified as cut-off are expected to produce smaller adjustments to income but it doesn't seem like this factor should be controlling. The rules should be modified to provide the use of a Section 481(a) adjustment uniformly to avoid taxpayer confusion and to provide for a transition between methods that avoids large fluctuations in taxpayer income. 2) It is requested that a transition rule be created for the implementation of accounting method changes to long-term contract methods to allow the elective use of the cut-off method in cases requiring the use of the Section 481(a) adjustment under these proposed regulations. Taxpayers with long-term contracts often must engage in long-term tax planning related to the change in long-term contract accounting methods. This must often be done to avoid the negative effects of the historical cut-off method. To immediately transition to a Section 481(a) adjustment implementation after planning for a cut-off implementation may likewise cause hardship to the taxpayer. For example, a change from EPCM to CCM may produce a negative 481(a) adjustment in the year of change plus result in reporting lower taxable income on contracts entered into in the year of change. Under Rev. Proc. 2002- 19, the negative Section 481(a) adjustment would all be recognized in the year of change. The taxpayer would report lower income under the Section 481(a) implementation than they would have using the cut-off method. Again, such swings in taxable income can result in undue hardship because of graduated tax rates and the rules related to net operating loss creation and usage. An elective right to use the cut-off method during a transition period would prevent such hardship. Provisions Related to Specific Severing and Completion Rules Requested Comment Provision The IRS and the Treasury Department, under the proposed §460 Regulations, have requested comments on the circumstances (if any) in which it would not be appropriate to require severing and completion of a home construction contract to be determined on a dwelling unit by dwelling unit or lot by lot basis, or when a contract is not for the sale of a dwelling unit or lot, on the basis of when the taxpayer receives payment(s) under the contract. Executive Summary of Respondent’s Comment We do not believe that it would be appropriate to apply severing and completion of a home construction contract on a dwelling unit by dwelling unit or lot by lot basis when the taxpayer is a site contractor, general building contractor or a subcontractor whose contract is not for the direct sale of a dwelling unit or lot. The site contractor, general building contractor or subcontractor does not generally contract directly for the sale of an individual dwelling unit or lot. In the normal course of business, these taxpayers contract with a developer for the preparation or construction of several lots or dwellings under a development project. The site contractor, general building contractor or subcontractor does not have a contractual price or delivery date that is contingent on a dwelling unit by dwelling unit or lot by lot basis. The contractor agrees to deliver the entire project at a specified price for the entire project. The contract between the contractor and developer does not identify a specific price per dwelling. The application of new severance and completion rules to contractors performing home construction contracts would place an undue burden on internal cost accounting and bookkeeping functions for those contractors. The contract for the construction of several dwellings in a subdivision or a condominium project consisting of several units is normally priced at a lump-sum figure for the entire project. The costs of the construction are accumulated on the basis of the entire project and not on a dwelling unit or individual lot basis. The IRS under Reg. Sec. 1-460-1(c)(3)(i) provides for rules that define the completion date for a contract using the completed contract method to report income. The IRS, under Reg. Sec. 1-460-1(e)(2), currently has in place rules regarding the severance of contracts. These rules are based on the facts and circumstances of the three factor test of: (1) independent pricing; (2) separate delivery or acceptance; and, (3) reasonable businessperson. We recommend that these current contract completion and severance rules should remain in place and be applied to contractors performing home construction contracts. Rationale for Comments Regarding Completion and Severing The rationale for our comment starts by stating again that we do not believe that it would be appropriate to apply severing and completion of a home construction contract on a dwelling unit by dwelling unit or lot by lot basis when the taxpayer is a site contractor, general building contractor or a subcontractor whose contract is not for the direct sale of a dwelling unit or lot. The current regulations for §460 were finalized in TD 8829, Long-term contracts, Code Sec. 460, 1/11/2001. The final regulations provide rules for determining the completion date of a contract using the completed contract method (CCM). The final regulations also provide rules for severing contracts as necessary to clearly reflect income. Completion Date of Contracts Regulation §1-460-1(c)(3)(i) provides that a taxpayer’s contract is complete upon the earlier of: 1. Use of the subject matter of the contract by the customer for its intended purpose (other than testing) and at least 95% of the total allocable contract costs attributable to the subject matter of the contract have been incurred by the taxpayer; or 2. Final completion and acceptance of the subject matter of the contract. Under subsection (iii) of this Regulation, a subcontractor’s customer is the general contractor. This Regulation provides specific guidance to determine a contract’s date of completion for inclusion of that contract into the taxpayer’s taxable income. The construction contract agreement for site contractors, general building contractors, and subcontractors normally provides for a completion date for the entire project and not for individual dwelling units or lots. There is generally no contractual stipulation for delivery dates of individual dwelling units or lots; rather it is for the project as a whole. Example: Quality Builders, Inc., a general building contractor and a calendar year taxpayer, contracts with Metro Development II, LLC to build a 10-story, 80-unit residential condominium complex known as Lake View Towers. The contract language requires that Quality must achieve substantial completion of Lake View Towers (the project) 24 months from the date of commencement. The date of commencement is determined to be March 1, 2008. If we assume that the project stays on schedule with no extensions of time, then the contractual completion date would be March 1, 2010. It is anticipated that on this date, the project would be ready for use and occupancy and Quality would have incurred at least 95% of anticipated cost. Quality would report its income from the Lake View Towers project in its tax return for the year ended December 31, 2010. Severing of Contracts Regulation §1.460-1(e)(2) provides a facts and circumstances test to determine the severance or aggregation of a contract. The facts and circumstances are determined under the following factors: (1) independent pricing of items in an agreement; (2) separate delivery or acceptance of items that are the subject matter of the agreement; (3) if a reasonable businessperson would not have entered into separate agreements containing terms allocable to each separate contract. It is generally not in the nature of a contract between an owner/developer and a site contractor, general building contractor, or subcontractor to individually price or deliver individual dwelling units or lots. The contract price is written to encompass the cost of the entire project. The owner/developer is the party that is best able to allocate the total cost of the development to the individual lots and dwelling units. Also, the owner/developer is the party that controls the sales of the individual dwelling units or lots. Neither the site contractor, the general building contractor, nor the subcontractor controls to whom the units or lots are sold, when they are sold, or the selling price. There is generally no contractual duty for the contractor to deliver individual units or lots outside of the project as a whole. A reasonable businessperson would certainly not think, under our example above, that Quality should enter into 80 individual contracts with Metro Development for the Lake View Towers project. Quality must construct the common areas of the project as well as the individual units. The project cannot be used for occupancy until a permanent certificate of occupancy is issued by the local codes department. The common areas must be complete before the certificate of occupancy will be issued. The current rules regarding severance of contracts should continue to be used as the guideline for the final regulations. Undue Accounting Hardship on the Contractors The introduction of new severing and completion rules that attempt to require a contractor to report income on a payment received basis will place an undue hardship on the accounting and bookkeeping of the contractor. Also, such rules would not lead to a clear reflection of income. The contractor who bids and performs a project that is a home construction contract and has more than one dwelling unit or lot normally prices the work as a whole or lump-sum and not on a dwelling by dwelling or lot by lot basis. Also, the contractor does not accumulate costs of the project on a dwelling unit by dwelling unit or lot by lot basis. The costs of the entire project are accumulated and payment is received based on the progress of the entire project. Example: Amp Electric, Inc, an electrical subcontractor is awarded the contract to perform all of the electrical scope of work on the Lake View Towers project as described in the previous paragraph. The contract is to provide all of the electrical required for the 80 dwelling units, the common areas, parking areas and landscape lighting. The contract amount is $8,000,000 and the estimated cost of the contract is $6,500,000 with an estimated gross profit of $1,500,000. The date of completion by contract is 24 months from the date of commencement. Amp compiled its bid based on the entire project. Amp is not contractually bound to receive payments based on a specific dwelling unit or units and is not contractually bound to deliver specific units. Amp must adhere to the project work schedule that is established by the general building contractor. The general building contractor submitted his bid and work schedule based on the entire project and not on individual units. The building of the project requires the general building contractor to coordinate the work of all of the subcontractors in order to complete the entire project within the time frame. The schedule of the work is not performed on a unit by unit basis, but is interdependent on all of the tasks. It would be impractical to require the contractors to enter into 80 separate contracts to build the project and attempt to segregate the costs accordingly. Conclusion We recommend, based on our comments as stated above, that the current contract completion and severance rules should remain in place and be applied to contractors performing home construction contracts.