Homebuilders recently scored a major tax victory by securing the ability to carry back certain losses — referred to as “applicable net operating losses (NOLs)” — for five years. Ordinarily, under the Internal Revenue Code — specifically, Section 172(b)(1)(A)(i) — an NOL can be carried back only two years preceding the taxable year in which the NOL was sustained.1 However, some homebuilders were not satisfied with only a five-year carryback and sought to classify a portion of their NOLs as “product liability losses,” which are eligible for a 10-year carryback. But this effort has been summarily rejected by the Internal Revenue Service in a chief counsel advice memorandum (CCA).2

The taxpayer to which the CCA pertained was a “major homebuilder.” The homebuilder incurred NOLs for its taxable years ending in Year 1 and Year 2, “because of severe weakness in the real estate industry.” As explained in the memo, the homebuilder provides the buyers of its homes with a limited A-Year warranty on workmanship and defective materials, a limited B-Year warranty that says certain systems (such as septic systems) will satisfy specified performance standards, and a limited C-Year warranty on structural and major construction defects. Most of the deductions under consideration were for correcting A-Year warranty defects.

All or most of the liabilities incurred by the homebuilder were caused by “poor workmanship” in the installation of the parts and supplies that comprised the homes, rather than by inherently defective parts and supplies. At issue was whether the homebuilder’s liabilities arising from its breach of warranties qualified as product liabilities. The answer was no.

Here’s the rationale. The portion of an NOL that qualifies as a “specified liability loss” (SLL) may be carried back 10 years. In Section 172(f)(1)(A), the tax code defines an SLL, in part, as the sum of the following amounts: any amount allowable as a deduction under Section 162 or Section 165 that is attributable to (1) product liability or (2) expenses incurred in the investigation or settlement of, or opposition to, claims against a taxpayer based on product liability.

Further, 172(f)(4) defines product liability as liability of the taxpayer for damages caused by personal injury or emotional harm to individuals, or damage to or loss of the use of property caused by any defect in any product that is manufactured, leased, or sold by the taxpayer. The caveat: the injury, harm, or damage must arise after the taxpayer has completed or terminated operations with respect to, and has relinquished possession of, the product.

“[U]nder the tax rules…product liability does not include liabilities arising under warranty theories relating to repair or replacement of the property that are essentially contract liabilities.” — Robert Willens

In short, product liability encompasses liability for damages caused by damage to or loss of the use of property caused by a defect in any product manufactured by the taxpayer.

“Property” Does Not Encompass the Product Itself
The IRS noted that some courts have concluded that buildings do not constitute “products” for product liability purposes.3 However, even if it is appropriate to treat the dwellings at issue here as products, the damages at issue do not qualify as product liability. This is because the products are the completed dwellings, and the damages at issue are damages to the product itself.

Such damages, the IRS concluded, do not constitute property damage under Section 172(f)(4). In fact, according to East River Steamship Corporation v. Transamerica Delaval, Inc., 476 US 858 (1986), “…damage to the product itself has certain attributes of a products liability claim…. But the injury suffered…is the essence of a warranty action, through which a contracting party can seek to recoup the benefit of its bargain….”

When a particular element, such as a window, becomes an integral part of a home, and a defect in the element or the faulty installation of the element results in damages to other parts of the home, the majority of courts have concluded that the problems constitute damages to the product itself. Therefore, the damages claimed do not constitute damages to other property.

The damages at issue in the CCA discussed in this column arose from warranty claims that the homebuilder’s customers asserted against the company as a result of the failure of the homes to satisfy expectations related to quality. The products were the entire homes, not individual components that became an integral part of the homes. Consequently, all the liabilities that the homebuilder satisfied by repairing and replacing components of the homes related to the various warranties constituted contractual repair or replacement liabilities, not product liabilities. And under the tax rules, specifically Regulation Section 1.172-13(b)(2)(ii), product liability does not include liabilities arising under warranty theories relating to repair or replacement of the property that are essentially contract liabilities.4

Defects
The IRS further stated in the CCA memo that “…we are also of the view that the damages in this case are not attributable to a product defect….” To constitute product liability, the damages in question must be attributable to a product defect. Defects, the IRS noted, may be qualitative or may constitute safety defects. For Section 172(f)(4) purposes, the IRS concluded, defect means (only) a safety defect.

Although some of the defects giving rise to the damages at issue might, if left unattended for a sufficient period, ultimately result in the collapse of the structure, none of the defects made the homes “unreasonably dangerous.” Therefore, the construction deficiencies did not make the homes defective within the meaning of Section 172(f)(4).

Accordingly, the portion of the NOL sustained by homebuilders attributable to repairing the homes pursuant to the warranties may not be carried back 10 years. That portion of the NOL did not meet the standards for classification as a product liability loss. As a result, in this case, the liability for damages was not on account of damage to or loss of the use of property caused by any defect in any product manufactured by the homebuilder.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.

Footnotes
1 Section 13 of the Worker, Home Ownership, and Business Assistance Act of 2009, Public Law 111-92, amended Section 172(b)(1)(H) to allow taxpayers to carry back an applicable NOL for a period of three, four, or five years. An applicable NOL is the taxpayer’s NOL for a taxable year ending after December 31, 2007, and beginning before January 1, 2010. Section 172(b)(1)(H)(iv) limits the amount of an NOL that a taxpayer elects to carry back to the fifth taxable year preceding the taxable year of the loss to 50% of the taxpayer’s taxable income for the carryback year. Moreover, Section 172(b)(1)(H) does not apply to any taxpayer (or member of its affiliated group) that received certain benefits (even though repaid) under the Emergency Economic Stabilization Act of 2008.
2 See CCA 201006028, November 5, 2009.
3 See Heller v. Cadral Corporation, 406 N.E. 2d 88 (Ill. App. Ct. 1980).
4 See Harvard Secured Creditors Liquidation Trust v. I.R.S., 568 F.3d 444 (3rd Cir. 2009). A division of Harvard Industries (HI) manufactured “lock-nuts” for use in commercial and military aircraft. HI sold the lock-nuts to distributors who then sold them to manufacturers for incorporation into the aircraft. It was discovered that certain lock-nuts sold by HI to the distributors were defective. HI’s largest customer, H, filed suit against HI based on the sale of defective lock-nuts. The suit was settled; HI paid H $820,000. In addition, HI entered into settlement agreements with several other distributors to which it had sold lock-nuts. In these settlements, HI forgave a total of $3,009,807 in accounts receivable arising from the sale of lock-nuts. At issue was whether the damages HI sustained were product liabilities. The answer was no. The Third Circuit noted that product liabilities encompass liabilities for damages resulting from damage to or loss of the use of property on account of any defect in any product manufactured by the taxpayer. The question, therefore, was whether the distributors’ inability to resell the defective product qualifies as damage to or loss of the use of property. The court concluded that such inability did not qualify as damage to or loss of the use of the property. Where the only injury was to the product itself, the resulting loss is essentially the failure of the purchaser to receive the benefit of its bargain — typically the “core concern” of contract law. Citing East River Steamship Corporation with approval, the court concluded that “…a manufacturer…has no duty…under either a negligence or products liability theory to prevent a product from injuring itself….”