Tax Court allows deferral of income held in trust

The Tax Court has ruled in Continuing Life Communities Thousand Oaks LLC et al. v. Commissioner (T.C. Memo. 2022-31) that a taxpayer following its financial statement treatment for recognizing certain upfront fees held in a third-party master trust account was on a permissible method of accounting that clearly reflected its income. The favorable result may provide helpful guidance in other situations where deposits or payments must be held in trust for services provided over a time period.

The case was brought by Continuing Life Communities Thousand Oaks LLC (the “Taxpayer”), which operates a continuing care facility in California that provides housing and health-care services to seniors in need of assistance. Per the agreement between the Taxpayer and its residents, there are two main fees: (1) the residents must deposit a large upfront fee (the “contribution amount”) into a third-party managed master trust, which covers lifetime care for the residents; and (2) pay monthly service fees that cover various costs such as utilities. Because of the unique nature of the industry (i.e., providing lifetime care for residents), California law requires that continuing care facilities hold the contribution amounts in third-party master trust accounts to ensure that continuing care facilities stay solvent. When a resident voluntarily leaves the facility or passes away, the Taxpayer is entitled to a portion of the contribution amount (the “Deferred Fee”, which is between 5% and 25%, depending on the amount of time that a resident stayed at the facility), which is paid to it by the Master Trust whenever a new resident moves into the vacant unit.

The Taxpayer followed generally accepted accounting principles (GAAP) and the American Institute of Certified Public Accountants (AICPA) Audit and Accounting Guide Statement of Position 90-8 (“Position 90-8”) to recognize revenue in its financial statements. In doing so, the Taxpayer recognized revenue each month for the monthly services fees billed to the residents.

For the contribution amounts, the Taxpayer recognized revenue based on an actuarial computation that took into account the estimated cost of care for a particular resident, including life expectancy, and multiplied that by the Deferred Fee. When a resident voluntarily leaves or passes away, the Taxpayer would recognize the remaining balance of the Deferred Fee, which is prior to receipt of the cash from the master trust.

The IRS examined the Taxpayer’s returns for 2008-2010 and determined that the net effect was a deferral of income that was not a clear reflection of income because the Taxpayer should have recognized the deferred fee each year as the percentage increased because that was when the revenue was earned. The Taxpayer argued that following GAAP, in this case, clearly reflects income, and that Position 90-8 is the industry standard for continuing care facilities. Further, the Taxpayer claimed that the contribution amount was neither earned nor constructively received by the Taxpayer prior to a resident departing the facility.

In granting summary judgment in favor of the Taxpayer, the Tax Court agreed on both arguments: (1) that the Taxpayer’s practice was a clear reflection of income under Section 446; and (2) that the Taxpayer did not have an unconditional right to payment, therefore such amounts were not fixed under Section 451 because the all-events test had not yet occurred.

Section 446 states that a taxpayer must compute taxable income under the “method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.” Even though following GAAP is merely a factor in determining clear reflection of income (consistency and materiality being others) the Tax Court went further into determining if the method was “ordinary.” It acknowledged that Position 90-8 is the industry standard for other continuing care facilities across the country and was not simply this Taxpayer’s method for GAAP purposes. Therefore, the Tax Court had no reason to believe that following this method would not be a clear reflection of income.

Second, the Tax Court disagreed with the IRS that a certain percentage of the contribution amount was fixed and determinable each year under Section 451 (i.e., that it met the all-events test). In order to be a fixed right to compensation for services, the determination is generally made in the taxable year in which the services are completed, and the taxpayer has an unconditional right to receive the payment. Typically, that is the earliest of the date the payment is received, the date the payment is due, or the date of performance. The Deferred Fee was clearly received and due after a resident’s death or departure and the Taxpayer had no dominion over the contribution amount until it was received because it was held in a third-party master trust account (it was neither actually nor constructively received). In considering when the amount was earned, the Tax Court determined that the provision of lifelong care to the residents was a condition precedent to the Taxpayer earning the Deferred Fee (i.e., that the lifetime care obligation is the essential service that the Taxpayer provides and is the event that fixes the right to earn the Deferred Fee).

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