A home builder must pay a heavy price for classifying CEO and other employee salary and bonuses as salary expense when it should have capitalized them as product cost.
Frontier Custom Builders, Inc., recently brought a case to the U.S. Court of Appeals for the Fifth Circuit after losing at the Tax Court level. The case originally resulted because Frontier deducted $1.318 million in compensation paid to its CEO as salary expense, in addition to some other employee salaries and year-end bonuses.
On audit, the IRS reclassified most of these expenses as part of the product cost. A notice of deficiency was sent to Frontier in the amount of $653,272. Frontier immediately filed a petition with the Tax Court seeking redetermination of the alleged deficiency.
Because Frontier designs, builds and sells custom homes and improvements on real property, it is subject to an Internal Revenue Code section and regulations requiring producers of real property to capitalize, rather than deduct as an expense, all of their production costs.
Capitalizable costs include both direct and indirect costs of production. Indirect costs include service costs, only some of which must be capitalized.
There are three categories of service costs:
- Capitalizable service costs
- Deductible service costs
- Mixed service costs
Mixed service costs are only partially allocable to production and, to account properly for the proportion benefiting production activities, must be capitalized pursuant to a reasonable allocation method. The direct allocation method and the step allocation method are two examples of such methods.
The IRS determined that most of the salary expense of CEO Wayne Bopp was a mixed service cost. Therefore, it issued the notice to Frontier of a $653,272 deficiency. The Tax Court denied Frontier’s request for relief, stating that it was required to uphold the IRS commissioner’s ruling because a reasonable allocation method was used.
It was the Tax Court’s opinion that Frontier failed to present sufficient evidence to prove that most of Bopp’s time was spent on deductible services.
The U.S. Court of Appeals reviewed the commissioner’s determination of income for abuse of discretion. The method of allocation used by the commissioner in determining the amount of capitalizable mixed service costs was appropriate.
Therefore, the Court of Appeals affirmed the decision of the Tax Court (Frontier Home Builders, Inc. v. Commissioner, U.S. Court of Appeals, Fifth Circuit, 14-60518, Sept. 16, 2015).