Form 3115 Frame Home Builder

I have a potential new client SMLLC that came into our office that is being killed by taxes on receivables he might not collect or sell due to the credit of the buyers. Their principal code of business on their tax return is 236100, residential building construction. According to the tax payer, he was audit by the IRS five years ago and was told they had to use accrual basis of accounting without the installment sales because they were a manufacturing company of wooden frame home.

In journal of accountancy I found the following information: Joyner Family Limited Partnership v. Comm'r, T.C. Memo. 2019-159 . In this case the tax payer was permitted to exclude sales from notes receivables due to the notes not being cash equivalent because borrowers poor credit.

Can a 3115 be filed under the TJCA allowing manufacturers to change accounting method and treat the amount collected on notes as sales only since the a/r are not cash equivalent. TCJA requires the inventory to be expensed till the sale has accrued, will the COGS be recognized based on the percentage of the note received? This would be the equivalent of an installment sale. According to publication 537 dealers and sales of inventory are prohibited from using installment sales method. Would this tax payer pass the inventory test, since his manufacture home are in inventory till they sell?

Thanks for any feedback

C Peña CPA
McAllen TX

I'm not clear whether the builder you describe is in essence just a manufacturer, or is a developer who also owns and sells land.

In the Joyner case you mention, here's part of what the court said.

The issues for decision are: (1) whether JFLP is entitled to use the section 453 installment method to report the mobile home sales or the land-only sales; we hold for mobile homes sales, it is not, and for land-only sales, it is; (2) whether respondent may change JFLP from the cash receipts and disbursements method of accounting (cash method) to the accrual method; we hold respondent may not; and (3) whether respondent abused his discretion by requiring JFLP to report its income from the mobile home sales upon receipt of the notes on the basis of the notes’ face values and asserting a related section 481 adjustment; we hold he did.

There are questions including whether the builder is on the cash method, whether he can (must??) use the installment method, and whether he can change methods (or risks a forced change by IRS). Note that the cash equivalence issue relates to section 1001 even when installment reporting is not in play.

PLease read the case here https://casetext.com/case/joyner-family ... ip-v-commr, and reg. 15A.453-1, and section 1001, and come back with your thoughts on where your potential client fits.

The TP is using code 231600. It's not a manufacturer and it appears the TP has never said it was a manufacturer. The fact that an IRS agent said the TP is a manufacturer is immaterial. So the question is whether the TP, an AMTP, can use the installment method. Here are a couple of cites that may be helpful in addition to 15A.453-1:

Repeal of the Modification of the Installment Method for Accrual Method Taxpayers Notice 2001–22

§ 1.453–6 Deferred payment sale of real property not on installment method.
(a) Value of obligations. (1) In transactions included in paragraph (b)(2) of §1.453–4, that is, sales of real property
involving deferred payments in which the payments received during the year of sale exceed 30 percent of the selling
price, the obligations of the purchaser received by the vendor are to be considered as an amount realized to the extent of their fair market value in ascertaining the profit or loss from the transaction. Such obligations, however, are not considered in determining whether the payments during the year of sale exceed 30 percent of the selling price.

1.453-6 has been obsolete for quite some time.

Notice 2001-22 has extremely limited application, and as far as I can tell, none here.

Hi!

I responded to you on the other forum where you posted. Here is my response, in case you check here first:

I have worked closely with Brian Coddington on a couple of these and read the new regulations closely. I will share what I think I know, but none of my clients are in the same line of business as your client.

If the taxpayer is a small business taxpayer, then yes, the taxpayer may file form 3115 and change to the cash method. I assume that your client is not a "tax shelter" under the insane tax shelter rules involving the allocation of losses to a certain % of owners.

The taxpayer also may change its method of accounting for inventory. Read the 471 regs closely - the new rules are very detailed and important to understand. Your client has two choices: account for inventory as NIMS, which essentially means you capitalize the cost of the supplies and then expense the cost when the supplies are used. The huge benefit though is that you can elect out of 263A, avoiding capitalizing other costs to inventory. The second choice is to conform to the books and records maintained by the taxpayer. This second option offers a huge benefit if you comply closely with the rules. You cannot include the items formerly known as inventory in records to owners, applications for credit, etc. If you meet the rules and you expense costs for financial statement purposes (again, under a very broad definition of financial statement), you expense the costs for tax purposes too. Again, this is my understanding, and I didn't see anything to say otherwise for your client's line of business, but obviously, check carefully.

So you are looking at 3 accounting method changes: accrual to cash, how you account for inventory, and electing out of 263A.

Brian used to offer his services directly to tax professionals. The first time I worked with him, I prepared the 3115 and then he reviewed it. I quickly learned that it was in the client's best interest for Brian to prepare the form and then for me to check for typos and ask questions about parts of the form that I did not understand. He now works for another company, and I don't know his availability, but he is an amazing resource, if he is still available.

https://sourceadvisors.com/brian-coddington/

Hi, Nilodop,

Thank you for your comments. I did not follow up on the short research project I did on this subject and would like to better understand it. Hopefully this thread will educate me.

In the back of mind I vaguely recall an installment payment regulation which allowed sales of vehicles in inventory (pay here lot) to report based on the FMV of the notes, but I did not find it today...

Thanks for your input, regarding this issue. In trying to do the matching principal on sales and cost the installment method seems to be the only way to accomplish this. If the tax payer is selling a manufactured home for 80k and his gross profit is 50% and receives only 5K down payment his taxes on a 30% rate would be 12k when he only has received 5K, he is paying for taxes on sales he might not even collect due to the type of borrower over the next ten to fifteen years. Having to pay this types of taxes will make the tax payer close due to the cash crush from having to pay taxes on money he does not have.


In the Joyner case, it is mentioned they could not use the installment method for the sale of mobile home but were not required to report the sales from the notes till they received it due to the credit of the borrowers.

"Accordingly, JFLP may report income from the mobile home sales as of when it received the payments on the notes."

Again, is he selling frame homes or lots with frame homes. And is he constructing the homes after delivery (i.e., a contractor)?

He is only selling the frame home, and is delivering them already build, he makes modifications to the homes based on the customer request.

The Joyner case seems very relevant. He can't use the installment method per 453(b)(2)(A) and (B). He fits squarely in the Joyner facts.

He should report his gain or loss as indicated in reg. 1.1001-1(a) by showing sales equal to the cash received and the fmv of the receivables, taking into account the poor credit etc of the buyers. He'd show costs equal to his tax basis of the frame homes. He'd have a gain or loss accordingly. Further cash received would be income when it is received.

Yes he has inventory.
No he can't use the installment method.
I'm completely unclear where you reference TCJA requiring inventory to be expensed until the sle is accrued.
I don't want to read the whole TCJA to find where it discusses allowing mfrs. to change methods to report the way 1001 and the 1001 regs. already permit. Please link or quote it.

The Tax Adviser

Under Sec. 471 and Regs. Sec. 1.471-1, inventories are required to be used in a tax year in which the production, purchase, or sale of merchandise is an income-producing factor. The TCJA permitted taxpayers that meet the gross receipts test and that are not tax shelters under Sec. 448 to be exempt from Sec. 471 and to use either of the following methods:

Treat inventory as nonincidental materials and supplies (NIMS inventory method); or
Conform to the inventory method used in its applicable financial statement (AFS) (AFS Sec. 471(c) inventory method) or to the method in the taxpayer's books and records prepared in accordance with its accounting procedures if it does not have an AFS (non-AFS Sec. 471(c) inventory method).

It is important for small taxpayers to note that being exempted from keeping inventory under Sec. 471 does not necessarily translate to an immediate tax write-off for all inventoriable costs.

For taxpayers that choose to use the NIMS inventory method, the final regulations clarify that even though these amounts are treated as nonincidental materials and supplies, they still retain their character as inventory. The final regulations do not change the position that inventory treated as nonincidental materials and supplies is "used and consumed" in the tax year the taxpayer provides the inventory to a customer, and costs are recovered through costs of goods sold in that year or the tax year in which the costs are paid or incurred (in accordance with the taxpayer's method of accounting), whichever is later. The final regulations retain the general rule from the proposed regulations that the "used and consumed" threshold for NIMS is met only when the taxpayer sells the inventory. As such, manufacturers that convert raw materials into a work in progress or finished goods by year end but have not yet sold the inventory will not be able to deduct the costs under the final regulations.

Some taxpayers that are manufacturers may have taken the position that their raw materials are deductible when first used and consumed in the manufacturing process (e.g., when items enter the work-in-progress stage); these taxpayers will likely need to file a method change to comply with the final regulations. In addition, the final regulations clarify that taxpayers using the NIMS inventory method have to capitalize only direct material costs of the property produced or acquired for resale; hence, direct labor or indirect costs are not required to be capitalized under this method and may be deductible when incurred or paid.

The final regulations clarify that taxpayers may determine the amounts of the costs of inventory by using either a specific identification method, a first-in, first-out method, or an average cost method, but may not use the last-in, first-out, or any other method described in Sec. 471 or the regulations thereunder, including the lower-of-cost-or-market methods. Furthermore, inventory treated as nonincidental materials and supplies is not eligible for the Regs. Sec. 1.263(a)-1(f) de minimis safe-harbor election, since that election specifically scopes out inventory.

With respect to taxpayers that instead choose to follow the AFS Sec. 471(c) inventory method or non-AFS Sec. 471(c) inventory method, the final regulations clarify that costs that are normally required to be capitalized to inventory under Sec. 471(a) but are being expensed in a taxpayer's AFS, or books and records, can also be expensed for tax purposes. This method may be beneficial for taxpayers that currently expense inventoriable costs for book purposes, as tax can generally follow suit. Notably, a taxpayer must ensure that any inventoriable costs capitalized or taken into account for its AFS, or books and records, are paid or incurred under the taxpayer's method of accounting for tax purposes.

For taxpayers without an AFS that decide to follow the non-AFS Sec. 471(c) inventory method, if a physical count is taken but not actually used to capitalize and allocate costs to inventory, then such amounts may be deductible in the year paid or incurred. However, if a taxpayer uses a physical count to allocate costs to inventory and then makes a journal entry to expense these costs in its financial statements, this journal entry would be ignored for tax purposes, thus requiring the taxpayer to capitalize the costs in accordance with the physical count allocation.

If I could not solve the problem otherwise, I'd probably recommend distributing the notes receivable to the stockholder or selling them to a related entity.

anepcar, thanks for the excerpt. If he meets the very narrow rule and expenses inventory under the non-AFS 471(c) method, and doesn't blow it by doing the "However, ..." in the last sentence of the excerpt, yes, I think he can expense the inventory.

And if he only builds the frame houses upon order (thus the only inventory being work in process), even if he carries the inventory in an AFS it would only be the job(s) in process and he'd still recover the entire basis upon sale, showing a gain or loss depending on valuation of the receivable(s).

Pretty good result overall.

That does not sound very practical since this is how the business operates as opposed to a one off situation.

That does not sound very practical .... What is "that"? If you mean this, And if he only builds the frame houses upon order ..., I wasn't suggesting he operate that way; I was suggesting the result if he does operate that way. Are you seeing facts here that say one way or the other?

Nilodop,

So if the tax payer is keep track of materials and subcontract work per unit, their books look clean, and they do not do any other sort of allocation between units based on counts, they can expense 100% of this cost once the sales occurs no matter the amount of many received from customers based on the TCJA.
If they sell lets say 50 homes with a 10% down during the year for 4,000,000 with a cost of 2,000,000 and an OH of 800,000, their schedule C would only reflect the 400,000 in sales, 2,000,000 COGS and expenses of 800,000 for a total loss of -2,400,000 till the start to recuperating from payment in the following years.
Upon filing the 3115 to change them from accrual to cash basis, would this major adjustment be reflected as a mis. line entry on the schedule C with an explanation attached to the tax return?

In #12 I floated selling the notes to a related party or simply distributing them. Another alternative is to set up a cash method sales company and sell the real estate to it.

Nilodop, my not practical comment was directed toward Steve's suggestion #12 to distribute or sell the Notes.
Your #13 snuck in there while I typed.

Why is it not practical?

Because his business model is to sell these homes and take back a note. Apparently he does this always or frequently. IMO, it would be a pain in the butt to get rid of the notes after every sale.