Tax Court in Brief | Continuing Life Communities Thousand Oaks LLC v. Comm’r | IRS Discretion to Change Methods of Accounting and Abuse of Discretion

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The Tax Court in Brief – April 4th- April 8th, 2022

Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

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Tax Litigation:  The Week of April 4th, 2022, through April 8th, 2022

Continuing Life Communities Thousand Oaks LLC v. Comm’r, T.C. Memo. 2022-31 |April 6, 2022 |Holmes, J. | Dkt. No. 4806-15

One way to think about tax law is to view it as a series of general rules qualified by exceptions, and exceptions to those exceptions, and exceptions to those exceptions to those exceptions. This may be a helpful way to begin to think about the tax-accounting issue we have to analyze in this case.” –Holmes, J., Continuing Life at pg. 14.

Short Summary: The Tax Court addresses how a company that owns and operates a continuing-care community should account for upfront payments made by its residents when calculating taxable income. Continuing Life was based in California and was thus subject to specific state laws that required (1) the provision of care to an elderly resident for the duration of his or her life and (2) GAAP accounting. Continuing Life charged three fees: the Contribution Amount, the Deferred Fee, and monthly fees for operations expenses. The Contribution Amount ranged from $245,000 to $570,000 and was paid in trust to a third-party intermediary. The trustee was required to repay a resident’s Contribution Amount when the resident agreement terminated by the resident’s death, voluntary departure, or expulsion.

The Deferred Fee was a percentage of the Contribution Amount, ranging from 5% to 25%, depending on when the resident’s agreement terminated (e.g., 5% for termination 91 days to 1 year; 25% for termination after 4 years). The Deferred Fee was paid only when a resident dies or moves out (not for expulsion) and a new resident buys the unit and pays his or her own Contribution Amount. Continuing Life amortized and recognized as income a fraction of the Deferred Fees by using the straight-line method and the actuarially determined estimated life of each resident. When the resident moved or died, Continuing Life would recognize the remaining unamortized Deferred Fee as income. And, Continuing Life recognized the nonrefundable amount as income before it resold the departed resident’s residence. Because the estimated life of each resident was actuarially determined on a year-by-year basis, the method of accounting required yearly modifications to each resident’s estimated life expectancy. And because the method amortizes income over life expectancy, it allowed Continuing Life to defer recognizing the unamortized portion of the Deferred Fees until a resident’s agreement was terminated.

For the tax years at issue (2008-2010), Continuing Life accounted for 26 Deferred Fees, and in its tax return, Continuing Life had losses as its deductions were greater than its gross income: losses of $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.

Upon audit, the IRS—conceding that Continuing Life followed GAAP and guidance of the American Institute of Certified Public Accountants (AICPA)—nonetheless supplied a different method of accounting and proposed an increase of nearly $20 million of Continuing Life’s tax bill.

Continuing Life challenged that decision. At the Tax Court level, the IRS and Continuing Life agreed on the facts and both moved for a summary judgment.

Issues: Whether Continuing Life’s accounting for the Deferred Fees is permitted by the Internal Revenue Code, and even if that is true, must the Tax Court defer to the opinion of the IRS that a different method of accounting be used to determine Continuing Life’s tax liability?

Primary Holdings: 

Key Points of Law:

Insights: In Continuing Life, the issue presented for summary judgment was a focused one—whether there was any genuine dispute that Continuing Life’s accounting for Deferred Fees “clearly reflected income.” In deciding that issue in favor of the taxpayer, Judge Holmes provides an excellent analysis of the confluence of GAAP, the Internal Revenue Code, the Treasury Regulations, and over 100 years of judicial precedence. The opinion also provides a deep dive into the role of the Tax Court in determining whether the IRS has discretion (and, if so, what standard to apply in review of that discretion) in changing an accounting method of a taxpayer for determining tax liability. Judge Holmes notes that the IRS—in issuing a notice of deficiency based on a changed method of accounting—does not have to explain why it disagrees with a taxpayer’s method of accounting, nor must the IRS justify that disagreement with an administrative record. Thus, in a challenge of the IRS’s change of method of accounting, there is not necessarily an administrative record to evaluate whether the “opinion of the Secretary” was arbitrarily or capriciously applied, which places the Tax Court—based on traditional notions of “abuse of discretion” standard of review—in the position of granting victory to the IRS in practically every instance. The case of Continuing Life sidestepped that judicial review problem, mainly, because the issue was presented to the Tax Court on summary judgment, thus allowing Judge Holmes and the Tax Court to apply the interplay of GAAP, the Internal Revenue Code, Treasury Regulations, and caselaw to determine only whether Continuing Life’s method of accounting clearly reflected income. Whether or not the IRS will appeal the Continuing Life decision to the Ninth Circuit Court of Appeals or beyond is yet to be known.

Sic semper transit gloria mundi.”—Holmes, J., Continuing Life at pg. 41. (Translation: “Thus passes the glory of the world.”)