Academic journal article Missouri Law Review

Timing Is Everything: Shea Homes, Inc. V. Commissioner

Academic journal article Missouri Law Review

Timing Is Everything: Shea Homes, Inc. V. Commissioner

Article excerpt

Shea Homes, Inc. v. Commissioner, 142 T.C. 60 (2014).

I. INTRODUCTION

In 1986, the Internal Revenue Code ("Tax Code") was comprehensively revised for the first time in over thirty years as part of the Tax Reform Act of 1986 ("Act"). (1) In enacting this comprehensive reform, Congress was guided by three overarching objectives: achieving fairness, improving efficiency, and striving for simplicity in the Tax Code. (2) Before 1986, high-income taxpayers found ways to lower their effective tax rates through many tax shelters and loopholes in the Tax Code. (3) As a result, many of these wealthy taxpayers were paying lower tax rates than their less affluent, low-income counterparts. (4) With this perceived unfairness in mind, Congress consciously closed loopholes and eliminated tax shelters within the Act. (5) While critics still remain, the 1986 reform accomplished its goal of increasing fairness by ensuring that taxpayers with similar amounts of income paid similar amounts of taxes. (6)

With many traditional tax loopholes and shelters eliminated, two primary mechanisms for reducing taxes remain. The first of these methods involves manipulating the timing of income. The second, often referred to as the characterization of income, attempts to take advantage of lower capital gains rates, rather than ordinary income rates. (7) Shea Homes, Inc. v. Commissioner (8) is a perfect illustration of how the timing of income can be manipulated in order to achieve substantial tax benefits.

Shea Homes is a developer of massive residential neighborhoods that include hundreds of houses and elaborate amenities, such as clubhouses, pools, trails, spas, fitness centers, ballrooms, and parks. (9) In Shea Homes, the taxpayers reported income from activities on the "completed contract" method of accounting. (10) This accounting method provides that income shall be recognized whenever the contract is deemed complete, even if income is received before the contract is completed. (11) Shea Homes argued that its contracts were not completed upon the sale of each individual home in the neighborhood, but rather upon the completion of the entire neighborhood. (12) The Tax Court found in favor of the developer, allowing Shea Homes to defer nearly $900 million dollars of income from the sale of individual homes to subsequent years. (13)

One of the overarching goals of tax policy is the concept of matching the receipt of income with the imposition of a tax on that income. (14) If a tax is imposed before income is actually received, liquidity difficulties become self-evident because the taxpayer does not have the cash on hand to pay the tax. This issue has influenced how the Tax Code and accompanying regulations were written. (15) Applying this policy to long-term contracts, the general rule is that taxpayers must use the "percentage of completion" method of accounting. (16) Under this method, the taxpayer is required to recognize income as payments are received throughout the duration of the contract. (17) This makes sense because it reflects the overarching tax policy of matching the receipt of income with the imposition of a tax. By definition, a long-term contract takes more than one year to finish; (18) accordingly, if the taxpayer receives income and incurs expenses throughout the year, he should be required to include amounts received in income and deduct expenses incurred at the end of each year to appropriately reflect his economic position.

By contrast, a contract that qualifies as a home construction contract allows a taxpayer to account for income under the completed contract method of accounting. (19) Under this method, the taxpayer does not have to include anything in income until the contract is complete. (20) This is logical because a homebuilder typically does not receive any income until the home has been constructed and the buyer pays for the house at closing and receives the keys. (21) It would be unfair to impose a tax on the homebuilder in a year in which he did not yet receive any income from a potential buyer. …

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