Contractors and Completed Contracts

[JoshinNC]

I have a client who is a general contractor, building homes. He was operating as a sole prop in 2005, incorporated 1/1/2006. Under the completed contracts method he would not recognize any income/expenses on his homes until they are closed on, right? He had 3 homes that he began construction on in 2005 and completed/closed in 2006. Since he incorporated on 1/1/2006 can we take a deduction for all costs associated with these homes in 2005 on the 2005 Schedule C and have the half built homes be contributed to the corp with an adjusted basis of $0 (since he has already deducted his costs through 12/31/2005)? I am basing this on the assumption that the costs incurred by the sole prop are not costs of the corp, and are therefore not deductible by the corp, even under completed contracts. If this sounds wrong please let me know.

Thanks in advance!

[OldJack]

The client cannot normally 1040 deduct the cost until there is a sale/disposition. The client cannot deduct the 2005 expenses on his personal 1040 unless he is considering the property as sold at fair-market-value (with taxable gain) to the corporation rather than as a contribution in exchange for common stock. When a client tax-free exchanges an asset to a corporation for common stock it is at the lower of cost or fair-market-value that is transferred to the corporation at no gain/loss to the individual.

[JoshinNC]

would the transfer to the corporation not be a disposition?

I don't understand how he can 1040 deduct the expenses in the year of the corp's sale of the homes, since he is not selling them, the corp is. The incorporation documents reflect the transfer of all assets of the sole prop to the corp, including the inventory (in process homes being WIP inventory), in exchange for 1/2 of the shares of corporate stock (wife is other shareholder w/ no capital contributed).

Does this mean that he needs to attach a schedule C in 2006 for the sale of the homes that were begun as a sole prop and the corp only recognizes income on the sale of the homes begun after the incorporation occurred?

[Bird Legs]

Construction

The homes under construction at the time of incorporation will be transferred in to the
corp. as inventory, work in progress, etc. in exchange for the stock.
The same is true of completed homes that had not been sold at the time of
incorporation. They are inventory.
The only way the cost and sales be included on a Sched. C form 1040, is for the
corporation to remain inactive until a later date.

[JoshinNC]

so what happens to the costs incurred?

is the corp allowed to deduct them in the year of sale, even though they were not incurred in the previous year (due to the fact that the corp did not exist in the previous year)? I would think that the final Schedule C would include all costs incurred to the date of incorporation, with all costs associated with the sales after incorporation taken by the corp in the year of sale.

Maybe I'm a little confused. Pleae HELP!

[OldJack]

The Sch-C cost in progress at the time of the transfer to the corporation becomes the cost of the property (homes) for the corporation as though they purchased (tax-free sale from the individual..not the Sch-C) the homes.

Since the individual has a "tax-free transfer" it does not get reported on a 1040 Sch-C much the same as if the individual withdrew property to personal use from a Sch-C business it would not be reported on Sch-C.

If the individual did not transfer the property with cost in exchange for stock (ie: note receivable, cash, etc), the individual would have a deemed sale on 1040 Sch-C at fair-market-value with a 1040 taxable gain/loss.

[JoshinNC]

OK, how 'bout this?

Taxpayer sells the three uncompleted houses to the corp for the following amounts:

Lot 1 - $89,814 sale price ($156,198 basis)
Lot 2 - $64,774 sale price ($112,651 basis)
Lot 3 - $50,245 sale price ($87,383 basis)

Is this possible. Taxpayer is 50% owner of corp, 100% owner of uncompleted homes. Is a sale of this type between related parties allowed. I can't find anything that specifcally says no, but wanted to get some other opinions.

Can the difference between the basis and the sale price be a gift to the corp, subject to the lifetime and annual limits?

Thanks for any assistance.

[OldJack]

You got me lost with those numbers which appear to be a loss for the Sch-C. I can't understand why you want a loss or deduction on Sch-C for something that you would not be able to do if the individual just kept the homes until completed. I think related party rules would disallow the losses.

If you transfer the actual cost to the corp for stock you have your cost as stock basis for future corp operating loss deduction or capital gain when the corp is liquidated. True, you are giving 50% of the possibility of gain on the sale of the homes to other shareholders, but you are also giving possible losses and 50% of the income tax liability. If the shareholders agree that your client should benefit in some way for gains not recognized on the homes, this can be accommodated with a bonus salary from the corp or some other benefit.

[JoshinNC]

Taxpayer operated two Sch. C's in 2005

He also operated a very profitable ($190,000+ net profit) sole prop installing drywall. We combined the drywall and home building into one corp on 1/1/06. The losses on the home building Sch. C would be used to offset the income from the profitable sole prop. This is why we want to deduct the accrued home costs in 2005 on the final Sch. C for the home building business. Taxpayer understands that when he sells the houses in 2006 through the corp for $225,000+ he will incur substantial taxable income, but is willing to take that bite, as he will have 6 months to get the funds together to cover the tax liability.

Do you just think the losses would be disallowed, or can we identify some code section or precedent that would lead us to this belief?

Thanks for all the ongoing help!

[Unregistered]

Confused

He can not deduct costs before the house is sold. Completed contract means just that and is appropriate for home builders. I am "assuming" he wante 351 tax free incorporation. After the incorporation he can gift halve the shares to the wife. He will transfer in all assets-inventory, equipment etc and liabilites, contruction loans? and the net equity is what he contributes for stock.

Home builders do not get to deduct costs on projects before they reconize the income on sale. All are recorded when the contract is completed.

[OldJack]

Do you just think the losses would be disallowed, or can we identify some code section or precedent that would lead us to this belief?

No deduction is allowed for losses from sales or exchanges between certain related taxpayers [IRC§267(a)]. Two of the related parties mentioned that might apply to your case would be:

1) Members of the seller's family. brothers and sisters (whole or half), spouse, ancestors and lineal descendants [IRC§267(a), IRC§267(b)(1), IRC§267(c)(4)].

2) Controlled corporations. A taxpayer and his controlled corporation. Control is direct or indirect ownership of more than 50% in value of the outstanding stock [IRC§267(b)(2), IRC§267(b)(8)].

[Unregistered]

works for me Jack

I appreciate all of your help with this one. Now I have to explain to the client his $25,000 tax bill (plus interest since 4/15). I'll start the conversation with,

"Remember when I explained to you the effects of SE taxes on your total tax bill, and the fact that you should have been incorporated last year (when I wasn't your accountant)."

"Yes, I remember."

"Well, how about I give you a graphical example; your 1040."

Wish me luck.

JoshInNC