Taxpayer Beats IRS in Controversy Involving Payments to Continuing Care Community

(Parker Tax Publishing April 2022)

On April 6, the Tax Court decided a case relating to the tax treatment of upfront payments received by a business running a continuing care community, an issue it has not previously addressed in detail. The Tax Court ruled against the IRS and held that a business operating a continuing care community does not have to report such payments, which the business treated as deferred fees, from residents until it has completed its commitment to the resident who made the payment. Continuing Life Communities Thousand Oaks LLC v. Comm'r, T.C. Memo. 2022-21.

Background

The appropriate tax treatment of upfront payments by residents of a continuing care community to the business running the community is important to businesses across the nation that provide continuing care. And, as the population is aging, these businesses are multiplying. It is an issue that the Tax Court had not thoroughly addressed before a decision it issued on April 6 dealing with one such business, Continuing Life Communities Thousand Oaks, LLC (Continuing Life). Continuing Life is a continuing care community located in Thousand Oaks, California, and like other such communities, it promises to provide its residents with housing and health-care assistance and to do so for as long as the residents live.

California law requires continuing care communities to provide lifetime care. It calls this a "continuing care promise," and the contracts are called "life care contracts." If a continuing-care community in California fails to fulfill a continuing-care promise, then it is subject to criminal and civil punishment and will not receive any payment for its services. California also requires that continuing care communities provide financial statements to their residents and follow generally accepted accounting principles (GAAP) when they prepare those statements.

Continuing Life's services are provided under a Residence and Care Agreement (Residence Agreement), which makes what California law considers a continuing care promise and is a life-care contract. Continuing Life charges three fees: the Contribution Amount, the Deferred Fee, and monthly fees. For 2008 through 2010, the years at issue, the Contribution Amount ranged from $245,000 to $570,000 and was determined entirely by a resident's choice of floor plan - the resident's age, health, and life expectancy played no role in determining how Continuing Life set this amount. Residents do not pay the Contribution Amount to Continuing Life - they instead pay it to Kenneth Cummins as trustee of the Master Trust. When a resident makes this payment, the resident becomes a grantor of the Master Trust. Cummins and the Master Trust acts as a third-party intermediary between the residents and Continuing Life to ensure that Continuing Life's finances are in check and the residents' payments are properly accounted for.

The Deferred Fee is calculated as a percentage of the Contribution Amount. After an initial 90-day cancellation period, the Deferred Fee begins to accrue at 5 percent a year, maxing out after four years at 25 percent. Residents do not write checks for it themselves. It comes instead out of the Master Trust, but only when a resident dies or moves out and a new resident buys the unit and pays his or her own Contribution Amount. Any unpaid expenses that a departed resident still owes, and his or her Deferred Fee, come out of the Contribution Amount. Cummins on behalf of the Master Trust then pays the balance to the resident or his estate. Continuing Life gets no Deferred Fee if it expels a resident. From 2008 through 2010, a total of 27 residents left - 15 by death, 11 by voluntary departure, and only 1 by expulsion for good cause. Continuing Life did not receive any Deferred Fee from the resident that it expelled.

The final source of Continuing Life's income is the monthly fees. Continuing Life set these fees using the community's operating cost, the prior year's per capita costs, and other economic indicators. Besides the costs to provide lifetime care, these monthly fees pay other expenses, including electricity, water, gas, and trash collection. Continuing Life itemizes optional utilities, such as cable TV, internet, and telephone services, separately from these monthly fees.

AICPA Guidance Relating to Continuing Care Communities

In 1990, the AICPA released the AICPA Audit and Accounting Guide Statement of Position 90-8, which addresses many different accounting issues that continuing care communities face, including advance fees. Position 90-8 defines an advance fee as a "payment required to be made by a resident prior to, or at the time of, admission." Some continuing-care communities refund the total amount or a portion of the advance fee on the occurrence of a specified event. These amounts are called the "refundable portion," and the remainder is called the "nonrefundable portion." Under Position 90-8, the refundable portion is credited as a liability and the nonrefundable portion is accounted for as deferred revenue. According to the AICPA, "nonrefundable advance fees represent payment for future services and should be accounted for as deferred revenue....Nonrefundable advance fees should be amortized [to income over future periods based on the estimated life of the resident]."

Continuing Life's Accounting Method and Tax Return Reporting

California law required Continuing Life to follow GAAP and that is what it did in its tax return reporting. When residents pay the Contribution Amount (and this amount meets the AICPA's definition of an "advance fee") to Cummins, Continuing Life does not recognize any income. But as each year passes, Continuing Life amortizes and recognizes as income a fraction of the Deferred Fees (and these meet the definition of "nonrefundable advance fees") by using the straight-line method and the actuarially determined estimated life of each resident. When the resident moves or dies, Continuing Life then recognizes the remaining unamortized Deferred Fee as income. This also means that Continuing Life recognizes the nonrefundable amount as income before it resells the departed resident's residence and actually gets cash from the Master Trustee. Throughout this process, residents are paying the monthly fees which cover at least some of the operating costs of the community.

Observation: Continuing Life's accounting method has two notable effects. Because the estimated life of each resident is actuarially determined on a year-by-year basis, the method requires yearly modifications to each resident's estimated life expectancy. And because the method amortizes income over life expectancy, it allows Continuing Life to defer recognizing the unamortized portion of the Deferred Fees until a Residence Agreement is terminated, when Continuing Life accelerates recognition of the remaining unamortized Deferred Fees.

In accrual accounting, Code Sec. 451 and Reg. Sec. 1.451-1(a) provide that amounts are includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy. The key inquiry is about when a taxpayer has a fixed "right to such compensation." If, in the case of compensation for services, no determination can be made as to the right to such compensation or the amount thereof until the services are completed, the amount of compensation is ordinarily income for the tax year in which the determination can be made. This all-events test is the foundation of accrual accounting and a fundamental principle of tax accounting.

For the years at issue, Continuing Life reported substantial losses on its Form 1065, U.S. Return of Partnership Income, as its deductions were vastly greater than its gross income. It took losses of about $9.2 million in 2008, $3.15 million in 2009, and $850,000 in 2010. During those years, Continuing Life recognized Deferred Fee income of only $34,188 in 2008, $420,187 in 2009, and $421,727 in 2010.

The IRS audited Continuing Life, and in November 2014 sent a notice of final partnership administrative adjustment for the 2008-2010 tax years that proposed increasing Continuing Life's tax bill by nearly $20 million. Continuing Life disputed the assessment and took its case to the Tax Court. The parties agreed on the facts and both moved for summary judgment. The only issue was whether Continuing Life's accounting for the Deferred Fees was allowed under the Code.

The IRS argued that the contractual payment schedule fixed Continuing Life's entitlement to the Deferred Fees. According to the IRS, the yearly incremental additions to those Deferred Fees is a condition precedent, and any later events such as a breach of the agreement by Continuing Life are conditions subsequent. Continuing Life, the IRS contended, has a fixed right to the entire Deferred Fee after those first four years. The IRS observed that the probability that Continuing Life will not uphold its end of the deal after four years and the probability that it will not be paid are both very low.

Continuing Life countered that its lifetime care obligation is the condition precedent to receiving a Deferred Fee. It argued that the completion of the lifetime care obligation is the earliest that it could possibly recognize a Deferred Fee as income. Further, it reiterated that the Residence Agreement and California state law required Continuing Life to provide care for the life of a resident for it to have a fixed right to a fixed amount of a Deferred Fee.

Practice Tip: Generally, a condition that is within the control of the taxpayer or involves a future event that is routine or ministerial in nature is deemed a condition subsequent. In contrast to a condition subsequent, a condition precedent must be satisfied for a transaction of an accrual basis taxpayer to be completed.

Continuing Life also noted that, under Code Sec. 446, it gets to follow its own method of accounting as long as the method clearly reflects income and is followed consistently. It pointed out that Reg. Sec. 1.446-1(a)(2) provides 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." Continuing Life observed that the IRS agreed that its treatment of Deferred Fees was in accordance with GAAP standards for the continuing-care industry, but also recognized that caselaw over the decades has created an exception to this general rule to give the IRS discretion in determining whether a particular accounting method "clearly reflects income." Continuing Life insisted, however, that its method clearly reflected income and, for the IRS to disagree was therefore an abuse of that discretion.

Analysis

The Tax Court granted summary judgment to Continuing Life after finding that Continuing Life's accounting of the Deferred Fees clearly reflected income. With respect to the IRS's argument regarding conditions precedent and subsequent, the court pointed out that Reg. Sec. 1.451-1(a) speaks not of conditions precedent and subsequent but more plainly says that, in cases where a taxpayer's right to compensation for services requires that those services be completed, the amount of compensation is ordinarily income for the tax year in which such determination can be made. The "determination" in the instant situation, the court said, would be that Continuing Life had fulfilled its obligation to provide lifetime care.

Further, the court observed, the IRS's position would require the court to split Continuing Life's single lifetime commitment to its residents into two parts: the first being the initial four years, and the second being the indefinite remainder of a resident's stay. The court noted that the IRS didn't explain why the court should do this, nor did the IRS point to any cases where what would seem to be a single legal obligation can be split in two to enable part to be classified as a condition precedent and part to be classified as a condition subsequent. The court agreed with the IRS that the probability was low that Continuing Life would not in the end receive the Deferred Fees. However, the court said, while it agreed that the facts showed that it was unlikely that Continuing Life would not receive a Deferred Fee from a resident, a possibility's remoteness does not itself create a condition subsequent.

The court also noted that, although Continuing Life residents pay their Contribution Amount to Cummins as Trustee and he has the authority to make interest-free loans to Continuing Life, at no point does Continuing Life have any control over these funds as income, nor can it use them to pay taxes - it has to use them to improve the community's capital plant. The court also didn't see how GAAP's treatment of Deferred Fees in Position 90 - 8 would allow Continuing Life's management to get "loosey goosey" with their inclusion into Continuing Life's income. Position 90-8, the court observed, requires actuarial determinations of lifespans for individuals whose age is known. The population involved is relatively small and actuarial determination of life expectancy has a long history and is as objective as any numbers relating to a human population can be, the court said. The court saw no way in which Continuing Life's reporting of its income from Deferred Fees contradicted the purpose of tax accounting's treatment of income recognition.

For a discussion of the all-events test and the inclusion of advance payments in income, see Parker Tax ¶241,720.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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