LLC’s use of deferral method for advance payments upheld

The Tax Court found that an IRS Criminal Investigations Division agent and his wife, a school manager, could use the deferral method to report certain advance payments relating to their private school LLC-partnership. Further, the court upheld the treatment of payments that the couple made to the LLC-partnership as capital contributions and determined that the IRS failed to prove that the taxpayers lacked basis to deduct passthrough losses from the LLC-partnership. The Tax Court did, however, redetermine the LLC-partnership’s business expenses, disallowing some items due to lack of business purpose or lack of substantiation.

Aimee and Ryan Cvancara formed Desert Academy, a private early-elementary school, in 2003. For federal income tax purposes, the couple elected to treat the school as a partnership. The partnership’s initial Form 1065, U.S. Return of Partnership Income, did not indicate whether it was using the cash method or the accrual method to determine income, but it did indicate on its partnership returns for years 2004 through 2006 that the accrual method was used. Desert Academy deferred recognition of advance payments received during these years. During 2005 and 2006, two of the couple’s children attended Desert Academy. The couple made substantial payments to Desert Academy over the years and did not charge tuition for their children during 2005 and 2006. The Cvancaras reported losses from Desert Academy on their individual income tax return for 2003 through 2007. In 2009, the IRS determined deficiencies in the couple’s income tax related to tax years 2005 and 2006.

Advance payments. Regs. Sec. 1.446-1(c)(ii)(A) states that, generally, under the accrual method, income should be included in the tax year in which the right to the income is fixed and the amount of the income can be determined with reasonable accuracy. However, the IRS has recognized that it is sometimes appropriate to defer advance payments for services on a limited basis, and Rev. Proc. 2004-34 allows accrual-method taxpayers to use the deferral method to account for certain advance payments. Under the deferral method, a taxpayer must include the advance payment in gross income in the year received, to the extent that it is recognized in revenues in the taxpayer’s financial statements. The remaining amount of the advance payment must be included in income in the following tax year.

The IRS asserted that Desert Academy’s income should be determined using the cash method because the school’s records were incomplete and because the school used the cash method to account for its expenses. Further, the IRS contended that Desert Academy was ineligible to use the deferral method as described in Rev. Proc. 2004-34 because the advance payments were subject to a condition subsequent and, thus, were considered earned in the year of receipt.

The Tax Court determined that Desert Academy elected to use the accrual method of accounting and to use the deferral method for advance payments it received. The court pointed out that the IRS’s argument that the deferral method was inappropriate because the advance payments were subject to a condition subsequent was based on a misreading of Rev. Proc. 2004-34. According to the court, the revenue procedure does not make the existence of a condition subsequent controlling. Rather, it states that determining whether an amount is earned in a subsequent year must be done “without regard to whether the taxpayer may be required to refund the advance payment upon the occurrence of a condition subsequent.” Because Desert Academy was entitled to retain the advance payments only if it provided the services that it agreed to provide, it earned the advance payments in the year that the services were provided without regard to any condition subsequent. Thus, the court determined that Desert Academy properly applied the deferral method for the advance payments it received.

Partners’ payments to Desert Academy and basis in Desert Academy. Sec. 721(a) states that, generally, no gain or loss should be recognized by a partnership or its partners when a contribution of property is made to the partnership in exchange for a partnership interest. The partner’s basis in the partnership interest under Sec. 722 is the amount of money contributed plus the adjusted basis of other property contributed and is increased by the amount of gain recognized by the partner. According to Secs. 702(a) and 704(d), partners can generally deduct their share of the partnership’s losses to the extent that the partner has basis in the partnership.

The IRS contended that payments made by the couple to Desert Academy during 2005 and 2006 should be treated as tuition for two of the couple’s children rather than as capital contributions to the school. The IRS noted several cases in which the court had disallowed charitable contribution deductions, deeming the payments instead to be tuition payments because they were made in anticipation of receiving a substantial benefit in return. In addition, the IRS claimed that the taxpayers lacked basis in Desert Academy to be able to deduct its losses for 2005 and 2006.

The Tax Court ruled that the Sec. 170 provisions related to charitable contributions do not apply to this case. Further, the court reasoned that the couple’s payments to Desert Academy were capital contributions in substance rather than tuition payments. The couple did not make these payments anticipating receiving a benefit from the school, but instead made the payments because the school needed additional capital contributions to remain in operation.

With regard to basis, the court found that the IRS had the burden of proof because it had did not make a determination of the couple’s basis in Desert Academy in the notice of deficiency. The court further determined that the IRS had not proved that the taxpayers had insufficient basis to deduct Desert Academy’s losses in 2005 and 2006.

Redetermination of cost of goods sold. Sec. 162(a) allows a taxpayer to deduct ordinary and necessary expenses paid or incurred in carrying on a trade or business. However, Sec. 6001 provides that a taxpayer must generally maintain adequate records to substantiate the deductions or credits claimed.

The Tax Court redetermined Desert Academy’s cost of goods sold, disallowing some of the claimed expenses. The court determined that the taxpayer kept inadequate records to substantiate some of the expenses and that some of the expenses had no apparent business purpose. However, the court did allow 50% of the cost of certain items that lacked itemized receipts to be deducted, after reasoning that a significant percentage of the expenses were deductible business expenses.

Cvancara, T.C. Memo. 2013-20

By Beth Howard, CPA, Ph.D., assistant professor of accounting, Tennessee Technological University, Cookeville, Tenn.