The Lodge

The lodge was a 38-unit residence for those requiring hotel-type services. It had two-floor elevator service. The lodge offered four types of accommodations all of which had a private bath:

(1) Single room--residents of these units were required to eat in the main dining room three meals per day.

(2) Studio apartment with combination sink, two-burner range and refrigerator--residents were required to eat in the main dining room at least two meals per day.

(3) Expanded studio apartment with larger kitchen and approximately 50 percent more living space than a regular studio--residents1996 U.S. Tax Ct. LEXIS 13">*28 were required to eat in the main dining room at least two meals per day.

(4) One bedroom apartment with fully equipped kitchen, full bath, living/dining room, and bedroom with walk-in closet--residents were required to eat one meal per day in the main dining room.

Each of the four types of lodge accommodations required payment of an entry fee and monthly rent in accordance with a rental contract. Petitioner could revise the monthly rent with a minimum of 30 days' notice to the lodge residents. Separate payments were made for the meal service, medical costs, and other services. The rental contract did not specify 106 T.C. 237">*245 the length of the agreement. The rights to terminate the contract of both petitioner and the resident were similar to those rights under the apartment rental contract.

The entry fees and monthly rent (exclusive of meals) for the lodge units during 1988 were as follows:

Petitioner collected the entire entry fee before the resident moved into a lodge unit. If the entry fee was received more than 60 days prior to1996 U.S. Tax Ct. LEXIS 13">*29 the date of occupancy, the contract called for petitioner to credit the resident with interest at the rate of 10 percent per annum for the period between the date of deposit and the date of occupancy.

If the prospective resident terminated the contract prior to occupancy, petitioner refunded the entry fee plus any interest, less a discount of 5 percent of the entry fee. If the tenant terminated the contract or died within the first 20 years of occupancy, refunds would be made in accordance with a schedule attached to the contract, subject to a minimum discount of 5 percent of the entry fee. Such a schedule is not part of the record; however, after the first 5 percent the first year, the balance of the entry fee is taken into income by petitioner over the next 19 years.

Rest Home

The 30-bed rest home provided 24-hour nursing care in a homelike environment. Many private rooms allowed residents to use their own furnishings, creating a homelike atmosphere in an institutional setting. All meals, housekeeping, and laundry services were provided. The rest home did not charge an entry fee. There were no adjustments in the notice of deficiency pertaining to the rest home.

Health-Care1996 U.S. Tax Ct. LEXIS 13">*30 Center

The health-care center (center) was a 60-bed licensed, skilled nursing facility to serve residents' medical needs and was approved by Medicare, Medicaid, and major insurance 106 T.C. 237">*246 carriers. All Highland Farms residents had 24-hour skilled nursing care available to them at a moment's notice. Nursing care could also be provided within a residence for a limited time with the prior approval of the residence director. Residents of Highland Farms unable to care for themselves, in a short-term or long-term illness, were given priority for a bed in the center. The center offered physical, speech, and occupational therapy. The center's Social Services and Activities Department offered full-time counseling and therapeutic recreational programs for the center's patients. The center did not charge an entry fee. There were no adjustments in the notice of deficiency pertaining to the health-care center.

Petitioner's History

When petitioner entered into this industry in 1969, most retirement facilities in existence were church-sponsored. These were primarily life-care programs requiring a large nonrefundable lump-sum payment.

Petitioner was among the first privately owned businesses1996 U.S. Tax Ct. LEXIS 13">*31 to enter this field. A total of 21 individuals contributed $ 5,000 each to start the company. When petitioner was preparing to build its cluster homes and apartments, bank financing was not available for retirement communities. Petitioner viewed the entry fees and the cluster home purchases as a method of financing.

Petitioner filed a Declaration of Condominium (Declaration) with the Office of the Register of Deeds, Buncombe County, North Carolina, on April 3, 1987. The purpose of the Declaration was to create:

a condominium development providing for individual ownership of the real property estates consisting of the area of space contained in each dwelling unit in said buildings, and the co-ownership by the individual and separate owners thereof, as tenants in common of all the remaining real property * * *.

As of June 27, 1991, the overall average length of occupancy of an apartment unit by a particular resident was 5 years, 2 months. ⁸1996 U.S. Tax Ct. LEXIS 13">*33 As of June 27, 1991, the overall average length of occupancy of a lodge unit was 2 years, 4 months. ⁹ Petitioner's occupancy data was not analyzed on an individual resident basis. Petitioner opines that if occupancy were calculated on an individual resident basis, the average length of occupancy would have been longer than that by unit, since some residents changed apartments. The actuarial life expectancies of the lodge residents ¹⁰ upon their entry dates ranged from 3.0 years to 15.3 years. A sample of 15 of the 123 apartment residents exhibited life expectancies at entry ranging from 5.7 years to 15.3 years. ¹¹

Petitioner's Financial and Tax Accounting

Since its incorporation on February 25, 1969, petitioner has consistently maintained its books and records, and filed its corporate tax returns, on the accrual method of accounting, using a taxable year ending December 31. Its tax accounting has been consistent with its financial accounting.

On November 28, 1990, the American Institute of Certified Public Accountants (AICPA) released its Statement of Position 90-8 entitled "Financial Accounting and Reporting by Continuing Care Retirement Communities" (SOP 90-8). SOP 90-8 addressed financial accounting standards, not tax accounting standards, providing guidance on applying generally accepted accounting principles to transactions resulting from continuing-care contracts. The provisions of SOP 90-8 were effective for fiscal years beginning on or after December1996 U.S. Tax Ct. LEXIS 13">*34 15, 1990, but accounting changes made so as to conform 106 T.C. 237">*248 to SOP 90-8 were to be applied retroactively. Petitioner's accountant, David Worley, reviewed petitioner's accounting methods and found them to be in compliance with SOP 90-8.

In its books, petitioner recorded the entry fees in "Advance deposit" account numbers 261 and 262 for the apartments and the lodge, respectively. The entry fees were not placed in escrow. Petitioner recorded 20 percent of the apartment entry fees as income in the year of receipt, and an additional 20 percent per year for the next 4 years, reducing account 261 accordingly. With respect to the lodge entry fees, petitioner recorded 5 percent as income in the year of receipt and the remainder over the next 19 years in accordance with the schedule provided to the residents as part of the rental contract, reducing account 262 accordingly. Similarly, for Federal income tax purposes, petitioner reported as income these same portions of the entry fees for the apartments and the lodge as they became nonrefundable or nonforfeitable within that tax year.

As of January 1, 1988, account 261 had a balance of $ 578,038, and account 262 had a balance of $ 1,066,982, for1996 U.S. Tax Ct. LEXIS 13">*35 a total of $ 1,645,020. As of December 31, 1988, account 261 had a balance of $ 628,577, and account 262 a balance of $ 1,131,830, for a total of $ 1,760,407. Thus, during 1988, the accounts had net increases of $ 50,539, and $ 64,848, respectively, for a total net increase that year of $ 115,387.

In its books, petitioner recorded 6 percent of the cluster home receipts as income in the year received and credited the remaining 94 percent to an account designated as "Liability for Repurchase". Petitioner's books treated a total of 24 percent of the purchase price as income over a 7-year period, with corresponding reductions in the liability account, as follows: 6 percent in year 1 and 3 percent per year in years 2 through 7. The liability for repurchase account was never reduced below 76 percent of the original purchase price of the cluster home.

For Federal income tax purposes, petitioner did not treat the cluster home transactions as sales. Petitioner reported the proceeds from the cluster home transactions in accordance with that year's reductions in petitioner's "liability for repurchase" amounts. Petitioner also claimed depreciation deductions on the cluster homes.

106 T.C. 237">*249 Respondent1996 U.S. Tax Ct. LEXIS 13">*36 audited petitioner's Federal income tax returns for the taxable years 1974 and 1975. Respondent made no changes to petitioner's method of accounting as a result of that audit.

Petitioner filed its Federal corporate income tax return (Form 1120) for the taxable year 1988, based on the calendar year, using the accrual method of accounting. Since late 1985, accountant David Worley (Worley) has prepared petitioner's returns and financial statements; the accounting firm of Deloitte, Haskins and Sells (DHS) had prepared those returns and financial statements completed prior to that time. Worley's firm reviewed the previous work of DHS, agreed with their preparation, and followed the same method.

In reviewing petitioner's Federal income tax return for the taxable year 1988, respondent determined that petitioner's method of accounting for the entry fees did not clearly reflect income in that the entire amount of the entry fees should have been reported in the year of receipt. Respondent adjusted petitioner's income to include $ 1,645,020 of unreported entry fees received through December 31, 1987, plus $ 115,387 of unreported entry fees received for taxable year 1988, for a total adjustment1996 U.S. Tax Ct. LEXIS 13">*37 of $ 1,760,407 related to the entry fees.

Respondent also determined that petitioner's method of accounting for the cluster home transactions did not clearly reflect income in that those transactions should have been accounted for as sales. Respondent increased petitioner's cluster home income by $ 5,001,633 based on petitioner's stated cluster home liabilities and by $ 1,079,098, consisting of cumulative unreported gain on cluster home sales and disallowance of cluster home depreciation claimed through taxable year 1988. Respondent has conceded the $ 5,001,633 adjustment. See supra note 2.

Respondent recomputed deductions for charitable contributions and net operating losses, calculated the environmental tax and corresponding deduction, and allowed a general business credit carryforward. On January 7, 1993, respondent issued the notice of deficiency with the resultant deficiency in tax in the amount of $ 2,531,650 and an addition for substantial understatement of income tax under section 6661 in the amount of $ 632,913.

106 T.C. 237">*250 OPINION

Entry Fees

Respondent argues that the entry fees are prepaid rent and are includable in income in the year of receipt. Petitioner contends 1996 U.S. Tax Ct. LEXIS 13">*38 the fees are neither rent nor payment for services, characterizing these "deposits" merely as a means of financing the construction of Highland Farms. Petitioner argues that its reporting of income from the entry fees is consistent with its method of keeping its books, and is thus a proper method of accounting. ¹² Petitioner also argues that since petitioner has no guarantee it will be allowed to keep the entire amount of any fee, inclusion in income should be ratable as the fees are "earned". ¹³ We agree with petitioner.

1996 U.S. Tax Ct. LEXIS 13">*39 Section 446(a) provides that taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes its income in keeping its books. The accrual method of accounting is one permissible method of computing taxable income. Sec. 446(c)(2). Petitioner is an accrual method taxpayer and has kept its books regularly in accordance with this method.

However, financial accounting and income tax accounting methods have divergent objectives. Thor Power Tool Co. v. Commissioner, 439 U.S. 522">439 U.S. 522, 439 U.S. 522">542-543 (1979). "Given this diversity, even contrariety, of objectives, any presumptive equivalency between tax and financial accounting would be unacceptable." Id. The general rule specifying use of the taxpayer's method of accounting is limited to cases where such method clearly reflects income. 439 U.S. 522">Id. at 541; see American Automobile Association v. United States, 367 U.S. 687">367 U.S. 687 (1961). Petitioner, thus, cannot simply rely on the consistency of its 106 T.C. 237">*251 tax accounting with its bookkeeping as a sufficient basis for upholding its treatment of income.

In considering the tax1996 U.S. Tax Ct. LEXIS 13">*40 treatment of deposits, the Supreme Court has held:

Whether these payments constitute income when received, however, depends on the parties' rights and obligations at the time the payments are made. * * * Whether these customer deposits are the economic equivalents of advance payments, and therefore taxable upon receipt, must be determined by examining the relationship between the parties at the time of the deposit. The individual who makes an advance payment retains no right to insist upon the return of the funds; so long as the recipient fulfills the terms of the bargain, the money is its to keep. The customer who submits a deposit to the [taxpayer] * * * retains the right to insist upon repayment * * * and the [taxpayer] therefore acquires no unfettered "dominion" over the money at the time of receipt.

In Indianapolis Power & Light, the taxpayer required customers with suspect credit to deposit an amount equal to twice the customer's estimated monthly utility bill to insure prompt payment of their bills. These deposits were refundable upon the customers' demonstrations of acceptable credit. The Supreme Court held that the utility customers' deposits were not advance payments, since the customers were under no obligation to purchase goods or services, and the customers' behavior controlled the amounts of the refunds. Therefore, the customers' deposits were not taxable income.

Similarly, in 96 T.C. 559">Oak Industries, Inc. v. Commissioner, supra, the deposits were intended as offsets to any unpaid fees, damages to equipment, or any other costs to the taxpayer due to a customer's breach. The customer who performed according to his or her obligations had a right1996 U.S. Tax Ct. LEXIS 13">*42 to a refund of the deposit. These deposits were not taxable income to the taxpayer.

106 T.C. 237">*252 In the instant case, the residents of the apartments and the lodge, if they decided to move out of their units, had a right to a refund of a portion of their entry fees in accordance with the schedules stated in their respective rental contracts. The refunds were within the residents' control, and petitioner had "no unfettered 'dominion' over the money at the time of receipt". At the time the entry fees were paid, the only amounts petitioner was guaranteed to be allowed to keep were the nonrefundable portions. Thus, we hold that the refundable portions were not advance payments for services or prepaid rent. ¹⁴ As a result, petitioner is not required to include the entire amount of the entry fees in income in the year of receipt. Only the nonrefundable or nonforfeitable amounts each year constitute income. Petitioner included in income for a specific taxable year those portions of the entry fees for the apartments and the lodge that became nonrefundable or nonforfeitable within that tax year. This method of accounting for the entry fees clearly reflects income. It was an abuse of discretion for respondent1996 U.S. Tax Ct. LEXIS 13">*43 to conclude that the fees must be included in petitioner's income for the year of receipt. We hold for petitioner on this issue.

1996 U.S. Tax Ct. LEXIS 13">*44 Cluster Home Transactions

Respondent has treated the cluster home and condominium transactions as sales, requiring the gain from these transactions to be included in income in the year of receipt and disallowing the depreciation deductions petitioner took with respect to these units. Petitioner argues that its obligation to repurchase a cluster home or condominium unit created a security transaction in the nature of a mortgage, not a sale. We agree with respondent.

"Under North Carolina law, the test for determining whether a conveyance with an option to repurchase represents a true sale or merely a loan with a security interest 106 T.C. 237">*253 focuses on the intent of the parties and not the form of the transaction." Redic v. Gary H. Watts Realty Co., 762 F.2d 1181">762 F.2d 1181, 762 F.2d 1181">1185 (4th Cir. 1985) (citing O'Briant v. Lee, 214 N.C. 723">214 N.C. 723, 200 S.E. 865">200 S.E. 865 (1939)). The intention to create a mortgage must be established, not by simple declaration of the parties, but by proof of the facts and circumstances outside the deed which are inconsistent with an absolute purchase. 762 F.2d 1181">Redic v. Gary H. Watts Realty Co., supra at 1186;1996 U.S. Tax Ct. LEXIS 13">*45 O'Briant v. Lee, 214 N.C. 723">214 N.C. at 731, 200 S.E. 865">200 S.E. at 870.

The North Carolina Supreme Court has identified six factors to be considered in determining whether a transaction is a sale or a loan:

(1) whether there was a debtor-creditor relationship created at the time of the transaction * * *; (2) whether the "grantor" remains in possession or whether the grantee takes immediate possession of the property * * *; (3) whether the "grantor" was under distress and hard-pressed for money at the time of the transaction * * *; (4) whether the transaction originated out of an application for a loan * * *; (5) whether the purported sale price is less than the net worth of the property * * *; and (6) whether the "grantor" was obligated to exercise the "option to repurchase." * * *

In deciding whether a transaction constitutes a sale for tax purposes, this Court considers whether the burdens and benefits of ownership have passed to the purported purchaser; this is a question of fact to be ascertained from the intentions of the parties as evidenced1996 U.S. Tax Ct. LEXIS 13">*46 by the written agreements read in the light of the attending facts and circumstances. Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221">77 T.C. 1221, 77 T.C. 1221">1237 (1981). Factors considered have included:

(1) Whether legal title passes * * *; (2) how the parties treat the transaction * * *; (3) whether an equity was acquired in the property * * *; (4) whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments * * *; (5) whether the right of possession is vested in the purchaser * * *; (6) which party pays the property taxes * * *; (7) which party bears the risk of loss or damage to the property * * *; and (8) which party receives the profits from the operation and sale of the property * * *.

The cluster home and condominium transactions arose not out of petitioner's seeking a loan, but out of the purchasers' buying housing units in a retirement community. Petitioner made no representations to the purchasers, either orally or 106 T.C. 237">*254 in writing, that the transactions were loans or mortgages. Petitioner1996 U.S. Tax Ct. LEXIS 13">*47 agreed to convey in fee simple and the purchasers agreed to purchase the specified cluster home or condominium for the designated purchase price. Legal title passed from petitioner to the purchasers, and the deeds were recorded. The purchasers, then the owners of the cluster homes or condominiums, took possession of their cluster homes or condominiums and paid the property taxes, the fire and liability insurance, and the utility bills for the unit. The owners received the proceeds of the fire and liability insurance in the event of a loss. If an owner did not repair a partially destroyed cluster home or condominium, petitioner would deduct the repair costs from the repurchase price. While the repurchase price of a cluster home or condominium was less than its original sales price, it cannot be said that the original sales price was less than the full value of the cluster home or condominium. ¹⁵ The purchase agreement required the owners to obtain petitioner's permission to assign or convey the property; this indicates that cluster home owners had the right to assign or convey their cluster homes, although as a practical matter transfers had occurred in only two instances as of the1996 U.S. Tax Ct. LEXIS 13">*48 time of the trial. The Declaration of Condominium gave condominium owners the right to lease or rent their units with petitioner's approval of the prospective tenant; the Declaration of Condominium also provided that petitioner could not unreasonably withhold its approval. On balance these facts support the conclusion that the transactions were sales, rather than mortgages.

In the early years of its business, petitioner was unable to obtain commercial financing for the construction of its retirement community and was in need of funds. The accelerated payment schedule for cluster homes to be built as compared to those already built supports this. However, petitioner's continuing need for funds after constructing1996 U.S. Tax Ct. LEXIS 13">*49 the initial units is not shown by the record in this case.

Petitioner assumed an obligation to repurchase the cluster home or condominium for a minimum of 76 percent of the original purchase price when the purchaser died or decided 106 T.C. 237">*255 to sell the unit. If the unit were totally destroyed by fire or other disaster, the cluster home would revert to petitioner without repurchase by petitioner, but the owner received the insurance proceeds. Additionally, petitioner controlled whether it would be obligated to repurchase through its power to grant or deny permission to convey the property. This "obligation" to repurchase was an advantage rather than a disadvantage in that petitioner, by selling the cluster homes itself, reaped the difference between the repurchase amounts and the higher resale prices. Where petitioner repurchased cluster homes and resold them, petitioner received all of the profits; this tends to weigh against the transactions' being sales. However, while the cluster home or condominium owner did not receive the benefit of any appreciation in the fair market value of the unit, the owner was assured of receiving at least 76 percent of the original purchase price. In the event1996 U.S. Tax Ct. LEXIS 13">*50 that the real estate market for retirement homes collapsed, petitioner could bear any loss. Thus, petitioner and the owner each had both a benefit and a detriment in the repurchase arrangement. While the cluster home or condominium owner had to forgo the benefit of possible appreciation, he or his estate was assured of receiving at least 76 percent of his original purchase price, an assurance that aging members of a retirement community might find attractive, particularly compared to the usual church-sponsored retirement communities that required large, nonrefundable upfront payments.

Some of the above aspects of this transaction support petitioner's proposed characterization while others support respondent's. Under these circumstances, we believe that the most significant factor is the characterization of the parties to the transaction in their written agreement. Both petitioner and the "purchasers" of the properties in question had a significant interest in that characterization. The "sale" characterization used in the documents for underlying transactions gave the purchasers ownership which was potentially important for purposes of the purchasers' deduction of interest and real1996 U.S. Tax Ct. LEXIS 13">*51 estate taxes. If petitioner prevails, those tax benefits, and possibly others, would be jeopardized. In similar situations, we have required taxpayers who attempt to recharacterize the written terms of a transaction to adduce strong proof that the written contract was without economic 106 T.C. 237">*256 substance. North American Rayon Corp. v. Commissioner, 12 F.3d 583">12 F.3d 583 (6th Cir. 1993), affg. T.C. Memo. 1992-610; Commissioner v. Danielson, 378 F.2d 771">378 F.2d 771, 378 F.2d 771">775 (3d Cir. 1967), vacating and remanding 44 T.C. 549">44 T.C. 549 (1965); Ullman v. Commissioner, 264 F.2d 305">264 F.2d 305, 264 F.2d 305">308 (2d Cir. 1959), affg. 29 T.C. 129">29 T.C. 129 (1957). Petitioner has failed to produce such strong proof. Based on all of the above facts and circumstances, we hold that the cluster home or condominium transactions were sales. In light of this, petitioner had no depreciable interest in the cluster homes or condominiums, and respondent properly disallowed deductions for depreciation. Weiss v. Wiener, 279 U.S. 333">279 U.S. 333 (1929); Taube v. Commissioner, 88 T.C. 464">88 T.C. 464 (1987).1996 U.S. Tax Ct. LEXIS 13">*52 Petitioner is also taxable on the net gain on the sales transactions. See supra notes 2, 13.

Section 6661 Addition to Tax

Section 6661 provides for an addition to tax for the substantial understatement of income tax. A substantial understatement in the case of a corporation is an understatement that exceeds the greater of (1) 10 percent of the tax required to be shown on the return, or (2) $ 10,000. Sec. 6661(b)(1). If the taxpayer has substantial authority for the tax treatment of the item in question, or if the taxpayer adequately discloses the tax treatment of the item on the return, then the amount of the understatement for purposes of this section will be reduced by that portion of the understatement which is attributable to that item. Sec. 6661(b)(2)(B).

Petitioner made no disclosures on its return, so we need only consider whether substantial authority exists for petitioner's tax treatment of any of the items leading to the understatement. "There is substantial authority for the tax treatment of an item only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary positions." Sec. 1.6661-3(b)(1), 1996 U.S. Tax Ct. LEXIS 13">*53 Income Tax Regs. The substantial authority standard is less stringent than a "more likely than not" standard, but stricter than a reasonable basis standard. Sec. 1.6661-3(a)(2), Income Tax Regs.

As was stated above, the test under North Carolina law for determining whether a conveyance with an option to repurchase represents a true sale or merely a loan with a 106 T.C. 237">*257 security interest focuses on the intent of the parties. Redic v. Gary H. Watts Realty Co., 762 F.2d 1181">762 F.2d at 1185. This intention must be established by the facts and circumstances. 762 F.2d 1181">Id. at 1186. Our consideration of these facts and circumstances led to our conclusion that the cluster home and condominium transactions were sales, as respondent contended. However, some factors supported petitioner's position. Given the peculiarly factual nature of the inquiry, we think that petitioner can be said to have had substantial authority for its treatment of the cluster home and condominium transactions. Therefore, we hold that petitioner is not liable for the addition to tax for substantial understatement.

To reflect the above holdings and respondent's concession,

Decision 1996 U.S. Tax Ct. LEXIS 13">*54 will be entered under Rule 155.