Taxes in Your Practice: Tax court allows deferral of income for continuing care community
Scott E. Vincent
Scott E. Vincent is the founding member of Vincent Law, LLC in Kansas City.
Vol. 78, No. 3 / May - June 2022
The U.S. Tax Court recently addressed the tax treatment of up front payments a continuing care community business received from its residents, and the business reported as income in later years as called for under generally accepted accounting principles.
In Continuing Life Communities Thousand Oaks LLC v. Commissioner of Internal Revenue2, the tax court ruled against the Internal Revenue Service in holding that the business could treat the deferred fees as income when it completed its commitment to the residents making the payments.
Continuing Life Communities Thousand Oaks, LLC is a Delaware limited liability company with its principal place of business in California. Continuing Life Communities Thousand Oaks’ business is providing housing and care to seniors as their needs change, including housing, food, and care services like eventual skilled nursing care if needed. Continuing Life Communities Thousand Oaks charges residents large initial fees to move into its community and significant monthly payments to live there, which the court noted are similar to other communities in the continuing care industry.
To protect seniors against potential abuse, California law requires continuing care communities to provide lifetime care under “life care contracts.” California also places minimum standards on these contracts, including financial statements to residents prepared under generally accepted accounting principles (GAAP). The court indicated other states also have strict regulations on continuing care communities, making this a national consideration.
Continuing Life Communities Thousand Oaks’ residence agreement is a life care contract under California law and includes a contribution amount, as well as deferred and monthly fees. For the years in question, contribution amounts ranged $245,000-$570,000 based on the floor plan and residence chosen by the resident. The contribution amount for each resident was paid to a trustee of a separate master trust that provided financial protection and accounting to residents.
Deferred fees were based on a percentage of contribution amounts, accruing at 5% per year up to a maximum of 25%. Under the agreement, deferred fees were paid from the master trust when a resident died or moved out, and a new resident acquired the unit and paid his or her own contribution amount. After a resident died or moved out, the master trust paid the deferred fee and any other outstanding expenses, along with the balance of the original contribution amount back to the resident or his or her estate. Notably, the residence agreement referred to the deferred fee as a future payment, and Continuing Life Communities Thousand Oaks received no deferred fee if a resident was expelled, which does occasionally occur.
Continuing Life Communities Thousand Oaks’ monthly fees were set based on operating costs and economic indicators. These expenses included the costs to provide lifetime care and operating utilities like electricity, water, gas, and trash collection. Optional utilities like internet, cable TV, and telephone services were itemized separately from the monthly fees. If a resident with unpaid fees died, moved out, or was expelled, Continuing Life Communities Thousand Oaks subtracted the unpaid fees from the otherwise refundable contribution amount.
As required by California law, Continuing Life Communities Thousand Oaks followed GAAP for its tax reporting of payments received from residents. Accordingly, the contribution amount was not treated as income when initially paid. Instead, Continuing Life Communities Thousand Oaks amortized and recognized a fraction of the deferred fee as income yearly on a straight-line method based on the actuarially determined estimated life of the resident. When residents died or moved out, Continuing Life Communities Thousand Oaks immediately recognized the remaining unamortized deferred fee as income before it resold the residence and received cash from the master trust.
The tax court noted that amortization of deferred fees based on estimated lives of residents was actuarially re-determined annually, and the Continuing Life Communities Thousand Oaks was therefore able to defer recognizing unamortized portions of the deferred fees until termination of a residence agreement. As a result, Continuing Life Communities Thousand Oaks recognized relatively small deferred fee income during the years in question and reported millions of dollars of losses for tax purposes. On audit, the IRS disallowed Continuing Life Communities Thousand Oaks’ accounting method for the deferred fees, resulting in proposed deficiencies of nearly $20 million.
Tax court decision
The parties agreed on the facts, and both moved for summary judgment in tax court. The sole issue before the court was whether Continuing Life Communities Thousand Oaks’ accounting for deferred fees was allowed under the Internal Revenue Code.
Continuing Life Communities Thousand Oaks argued that it is allowed to follow its own method of accounting under Code § 446 unless it does not clearly reflect income or is not consistently followed. Continuing Life Communities Thousand Oaks also cited Treasury Regulation § 1.446-1(a)(2) for the proposition that a “method of accounting which reflects the consistent application of generally accepted accounting principles in a particular trade or business in accordance with accepted conditions or practices in that trade or business will ordinarily be regarded as clearly reflecting income.”3 Although case law exceptions have developed, Continuing Life Communities Thousand Oaks argued that it would be an abuse of discretion by the Commissioner of Internal Revenue to apply an exception since Continuing Life Communities Thousand Oaks’ method of accounting clearly reflects income.
The commissioner argued that the commissioner can determine whether a taxpayer’s accounting method clearly reflects income. The commissioner acknowledged there are limitations on this discretion but argued that Continuing Life Communities Thousand Oaks did not demonstrate abuse of discretion in this case.
The tax court decision provides an extensive outline of applicable law and historical cases addressing deferred income and applicable accounting methods. The court cited Treasury Regulation § 1.451-1(a) for the rule that where a right to receive compensation for services requires completion of the services, the compensation is ordinarily income for the tax year in which such determination can be made; in this case, when Continuing Life Communities Thousand Oaks has fulfilled its lifetime care obligation. The court also noted, and appeared to rely on, the fact that the residents’ contribution amount (from which deferred fees were ultimately paid) was held in a master trust and was not under Continuing Life Communities Thousand Oaks’ control or available for use to pay taxes. Finally, the court noted that applicable GAAP rules require consistent treatment and would not allow Continuing Life Communities Thousand Oaks discretion in reporting income, since it was governed by actuarial determinations. In the context of these factual findings, the court reviewed prior cases in a variety of contexts where following GAAP accounting may or may not have been adequate for tax purposes. Ultimately, the court found that in this case Continuing Life Communities Thousand Oaks’ compliance with GAAP and its overall accounting method clearly reflected income.
The court also acknowledged the commissioner’s discretion, noting that Treasury Regulation § 1.446-1(a)(2) contains the “remarkable sentence: ‘However, no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income.’”4 The court reasoned that the commissioner’s discretion has significant weight but recited prior cases holding that it cannot be exercised without consideration of the facts in a particular case and cannot be abused. Otherwise, the court noted the commissioner’s decision would be unreviewable.
Ultimately, the court decided that the facts and support for Continuing Life Communities Thousand Oaks’ treatment of the deferred fees under GAAP “fits snugly into the pattern of similar cases.”5 The court further found that, at least in this case, the commissioner’s discretion to change accounting methods should not overcome its conclusion, noting that “the history of how that discretion came to be weakens its power to overcome text, purpose, and analogy.”6 Based on these findings, the court granted summary judgment to the Continuing Life Communities Thousand Oaks.
Continuing Life Communities Thousand Oaks LLC v. Commissioner of Internal Revenue is an excellent review and analysis of the history and case law regarding deferred income and the interplay between financial and tax accounting. The case is also a good reminder that the commissioner has broad discretion to challenge and change a taxpayer’s accounting method. However, importantly, the U.S. Tax Court can find that the commissioner’s discretion does have limitations and can be challenged if it abuses that discretion.
1 Scott E. Vincent is the founding member of Vincent Law, LLC, in Kansas City.
2 T.C. Memo. 2022-31.
3 Id. at 7.
4 Id. at 21 (citing Treas. Reg. § 1.446-1(a)(2)).
5 Id. at 25.
6 Id. at 25.