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
- 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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