Defending the GAAP

Judge Mark V Holmes is back with one of his oldies-but-goodies, Continuing Life Communities Thousand Oaks LLC, Spieker CLC, LLC, Tax Matters Partner, T. C. Memo. 2022-31, filed 4/6/22. And the only reason the Oakies are still around can be found in my blogpost “Titular Signatory,” 8/3/16, when Mr. Spieker signed off on some SOL extenders.

But today I bet he’s glad he did, as Judge Holmes upholds his GAAP tax reporting of various items of future income in this continuing care operation. Those of us on short final for The Big Eight-Oh are often solicited by such operations, especially if the operators think we can stump up a quick half-mil for a floor plan.

“Continuing Life’s business is to provide housing and care to seniors even as their needs change. A new resident might need only housing and food, but as time batters away he may need more. And although Continuing Life is not a hospital, it does promise to provide for its residents’ needs all the way through skilled nursing care. The range of services that it promises costs a lot. And this is reflected in the entry fee—the initial payment that Continuing Life charges to move into the community—and in large monthly payments too. Continuing Life is no outlier—industry surveys show that the entry fees in similar communities average $402,000, with some at over $2 million, and that monthly service fees run between $2,000 and $4,000.” T. C. Memo. 2022-31, at p. 2 (footnote omitted, but it comes from a publication of AARP, of which I am an (un)retired member.)

The issue is not the upfront; that’s held in a unitrust which loans funds to the Oakies at no interest for capital recovery and improvements. It’s not the monthly $2K to $4K, that’s ordinary income, and operating expenses are deductions. It’s the so-called Deferred Fee.

If a resident dies or leaves voluntarily, they get back the upfront when the unit is resold less up to 25% thereof (depending upon how long they stayed). If they’re tossed for cause, they get it all back.

OK, so how do you treat these Deferred Fees? Every one of the residents will leave voluntarily or die, but who knows when?

AICPA, the CPAs’ guru, has the answer. Position 90-8. And no, that’s not an addendum to the Kama Sutra. “We’ll focus only on the provisions that are relevant for this case. The key provisions are those that deal with advance fees. Position 90–8, para. 15 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. The refundable portion is credited as a liability, and the nonrefundable portion is accounted for as deferred revenue. Id. paras. 20–23. For the nonrefundable portion, Position 90–8 again recognized the ‘wide diversity of practice exist[ing] among [continuing-care retirement communities] when accounting for nonrefundable advance fees.’ Id. para. 34. Although there are eight listed methods, only two are relevant here. Paragraph 35 provides that one method recognizes nonrefundable advance fees ‘as revenue in the period the fees are receivable if future periodic fees can reasonably be expected to cover the cost of future services.’ Paragraph 36 provides a second method, which defers recognition of nonrefundable advance fees and amortizes them into income as consideration for providing future services. This method treats the nonrefundable advance fees as future costs that ‘are not recoverable from other revenue sources.’ And, as a result, the matching principle requires that the nonrefundable advance fee be deferred until the expenses arise. The AICPA came down on the side of this latter method….” T. C. Memo. 2022-31, at pp. 11-12 (Footnotes omitted).

Now these operations are strictly regulated, and the Oakies had to use GAAP per CA law. So they straight-line amortized the Deferred Fees over the estimated life of each resident.

IRS says no, in this case GAAP does not clearly reflect Oakies’ income and expenses. The pick-up of Deferred Fees is too slow, and slugged the Oakies with a $20 million tax bill. Everyone agrees the Oakies used GAAP, but IRS says they get to choose what clearly reflects.

Now Section 446(a) says generally (love that word!) it’s gambler’s choice, so what the Oakies used consistently they can keep using. But the exceptions and exceptions to exceptions, and exceptions to exceptions to exceptions, are what keeps us tax lawyers in vodka Gibsons.

There’s enough case law to stock a good-sized law review article, but I’ll spare y’all.

There’s Supremes learning that IRS has more than the usual presumption of correctness when it comes to accounting methods. Ya see, GAAP is for management, investors, lenders, creditors, and certain regulators. IRS is there to guard the fisc, a supercreditor.

“Clearly” means honestly, straightforwardly, plainly, and frankly, but not necessarily perfectly, without fault or flaw. Judge Holmes laments that the case law is jumbled and scrambled, but that’s what we have.

“Yet on the undisputed facts of this case, some of these additional factors also favor Continuing Life: The expenses that Continuing Life incurs because of its continuing-care promise are expenses that it incurs over the entire lifespan of each of its residents, yet it is entitled to the Deferred Fees only when residents depart from the community. We can conclude from this that Continuing Life’s method matches income and expenses better than the accelerated treatment that the Commissioner proposes. We can also conclude from this that Continuing Life’s method, even when viewed on an annual basis, looks like a better match than the Commissioner’s because it recognizes income each year that a resident continues to live in the community and thus impels Community Life to incur expenses on that resident’s behalf.” T. C. Memo. 2022-31, at p. 20.

And the Deferred Fees are not so unique. “Deferred Fees are without doubt material to Continuing Life’s bottom line, but their treatment as an accrued item by a taxpayer following the accrual method doesn’t mark them as out of the ordinary (as it might, for example, for a cash-method taxpayer who uses accrual accounting for a particular item of material expense).” T. C. Memo. 2022-31, at p. 21.

Under the “all-events” test for recognition on the accrual basis, CA law and the Oakies’ operating license requires payment only on death or voluntary vacatur. Until then, the Oakies had to perform the services contracted for. No receipt or recognition by the Oakies until then, so life expectancy is a reasonable yardstick.

And the Oakies couldn’t touch the Deferred Fees until they performed.

IRS has discretion, but the Oakies win.