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

• Middleton v. Comm’r, T.C. Memo. 2022-28 | April 4, 2022 |Kerrigan, J. | Dkt. No. 8158-19L
• Scholz v. Comm’r, T.C. Summary Opinion 2022-5 |April 4, 2022 |Panuthos, J. | Dkt. No. 20743-19S
• Webert v. Comm’r, T.C. Memo. 2022-32 | April 7, 2022 | Gustafson, J. | Dkt. No. 15981-17
• Salter v. Comm’r, T.C. Memo. 2022-9 |April 5, 2022 |Lauber, J. | Dkt. No. 10776-20
• Norberg v. Comm’r, | April 5, 2022 | Lauber, A. | Dkt. No. 12638-20L
• Metz v. Comm’r, T.C. Memo. 2022-33 | April 7, 2022 | Weiler, J. | Dkt. No. 16784-19

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: 

• While the law is settled that the IRS has discretion to change a taxpayer’s accounting method, that deference is conditional: “If no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the [IRS], does clearly reflect income.” 26 U.S.C. § 446(b) (emphasis added). Here, there is no reason to conclude that Continuing Life’s use of GAAP accounting for the Deferred Fees takes it out of the ordinary rule that an accounting method consistent with GAAP accounting “clearly reflects income” under section 446. Summary judgment granted in favor of Continuing Life.

Key Points of Law:

• Accounting Methods and Reflection of Income. As a general rule, a taxpayer gets to follow its own method of accounting. See 26 U.S.C. § 446(a). However, an exception to this general rule is for methods of accounting that do not clearly reflect income or that a taxpayer doesn’t follow consistently. at § 446(b). 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.” Treas. Reg. § 1.446-1(a)(2).
• Regulations have the force of law, and can be trumped only by the Internal Revenue Code or the Constitution. See Adams Challenge (UK) Ltd. v. Comm’r, 154 T.C. 37, 64 (2020).
• Because a taxpayer follows GAAP in its accounting, does not mean that the IRS cannot challenge the tax liability otherwise shown by such accounting because GAAP and tax accounting have different purposes. “The primary goal of financial accounting is to provide useful information to management, shareholders, creditors, and others properly interested; the major responsibility of the accountant is to protect these parties from being misled. The primary goal of the income tax system, in contrast, is the equitable collection of revenue; the major responsibility of the Internal Revenue Service is to protect the public fisc.” Thor Power Tool Co. v. Comm’r, 439 U.S. 522, 542 (1979).
• Section 446, GAAP, and a Taxpayer’s Regular Method of Accounting. The Code provides four permissible accounting methods: cash receipts and disbursements; accrual; any method prescribed by chapter 1 of the Code; or a combination of the above methods that is prescribed by regulation. 26 U.S.C. § 446(c). All accounting methods must “clearly reflect[] income.” at § 446(b); Treas. Reg. § 1.446- 1(a)(2). “Clearly” as used in the statute means “plainly, honestly, straightforwardly and frankly, but does not mean ‘accurately’ which, in its ordinary use, means precisely, exactly, correctly, without error or defect.” Huntington Sec. Corp. v. Busey, 112 F.2d 368, 370 (6th Cir. 1940). Consistent compliance with GAAP in accordance with accepted conditions or practices in a trade or business “will ordinarily be regarded as clearly reflecting income.” Treas. Reg. § 1.446-1(a)(2).
• “The Regulations embody no presumption; they say merely that, in most cases, generally accepted accounting practices will pass muster for tax purposes. And in most cases they will.” Thor, 439 U.S. at 540.
• Section 451 and Rules for Inclusion in Income. In accrual accounting, “income is 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.” Treas. Reg. § 1.451-1(a). The key inquiry is about when a taxpayer has a fixed “right to such compensation.” “[I]f, 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 taxable year in which the determination can be made.” Id. The unconditional right to income, not receipt of payment therefor, is key. Hallmark Cards, Inc. & Subs. v. Comm’r, 90 T.C. 26, 32 (1988); Schlude v. Comm’r, 372 U.S. 128, 137 (1963).
• State law can fix a liability for accrual accounting purposes.
• A condition precedent is one that must be met before a fixed right to income arises. A condition subsequent ends an existing right to income but does not preclude the accrual of income. Keith v. Comm’r, 115 T.C. 605, 617 (2000); Charles Schwab Corp. v. Comm’r, 107 T.C. 282, 293 (1996), aff’d, 161 F.3d 1231 (9th Cir. 1988).
• “The fact that . . . [a taxpayer] knows with absolute certainty that in the next instant these rights [to income] will arise cannot compensate for the fact that . . . they do not exist.” Hallmark Cards, Inc. & Subs. v. Comm’r, 90 T.C. 26, 34 (1988). In Continuing Life’s scenario, for example, Continuing Life may know the exact amount of Deferred Fees (i.e., 25% after the passing of 4 years of residency), but Continuing Life hasn’t necessarily earned the income for income tax recognition purposes.
• The Commissioner’s Discretion—When and how to Apply? The law is settled that the IRS has discretion to change a taxpayer’s accounting method. The Internal Revenue Code requires deference to the opinion of the IRS as to a taxpayer’s accounting method. But, that deference is—by statute—conditional: “If no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary [of Treasury, i.e., the IRS], does clearly reflect income.” 26 U.S.C. § 446(b) (emphasis added). Thus, the question arises as to when the “opinion of the Secretary” may be supplied, and if supplied, challenged and overturned.
• “Discretion”—Congress routinely delegates functions to executive agencies, and those agencies exercise discretion in performing those functions. For example, where a taxpayer’s underlying liabilities are not at issue, the Tax Court’s review of a notice of determination is for “abuse of discretion.” See Sego v. Comm’r, 114 T.C. 604, 610 (2000). An abuse of discretion occurs if the agency exercises its discretion “arbitrarily, capriciously, or without sound basis in fact or law.” See Woodral v. Comm’r, 112 T.C. 19, 23 (1999); 5 U.S.C. § 706(2)(A); Motor Vehicle Mfrs. Ass’n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 41 (1983); Fargo v. Comm’r, 87 T.C.M. (CCH) 815, 817 (2004), aff’d, 447 F.3d 706 (9th Cir. 2006).
• The abuse of discretion determination is made by review of the whole record or parts of it cited by a party. 5 U.S.C. § 706. And, a court asked to decide if an agency has abused its discretion must usually review how the agency exercised its discretion on the basis of the administrative record, reviewing only the rationale that the agency used without regard to an alternative rationale that the court may have been available.
• The Courts of Appeals for the Ninth Circuit, Eighth Circuit, Sixth Circuit, and Second Circuit each use a different standard of review in a challenge of the IRS’s decision to change a taxpayer’s method of accounting pursuant to section 446(b) of the Code. See Sandor v. Comm’r, 536 F.2d 874, 875 (9th Cir. 1976); Ford Motor Co. v. Comm’r, 71 F.3d 209, 212 (6th Cir. 1995); RCA Corp. v. United States, 664 F.2d 881, 889 (2d Cir. 1981); Wal-Mart Stores, Inc. & Subs. v. Comm’r, 153 F.3d 650, 657 (8th Cir. 1998).

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.”)

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