The Internal Revenue Service surprised and alarmed retirement community operators recently when it challenged an operator of luxury continuing care retirement community's tax treatment of refundable entrance fees.
Classic Residence by Hyatt, which changed its name to Vi recently, owns more than 18 senior living communities and followed industry practice by treating the refundable portions of residents' entrance fees as loans with obligations to repay. In December 2009, the IRS sent a notice of deficiency for almost $129 million for the 2005 tax year to Classic insisting that the company should have treated the more than $318 million it received in mostly refundable entrance fees that year as taxable income "from rental/occupancy of the living units."
Classic has petitioned the Tax Court for redetermination of the deficiency and penalty, contending that because the refundable part of the fee bears an obligation to repay the resident, it is a loan and should be treated as such for tax purposes.
What makes the IRS stance surprising is that there is case law that seems to support Classic's position directly on point. In a 2007 federal court decision involving a resident of a Hyatt facility, John O. Finzer et ux. v. United States, 496 F. Supp. 2d 954 (N.D. Ill. 2007), the court explicitly described the refundable portion of a retirement community entrance fee "as a loan." The agreement at issue in Finzer provided that if the agreement was terminated for any reason, including the death of the resident, there would be a refund. In addition to Finzer, there are other court rulings and several advice memoranda from the IRS that also appear to support treatment of a refundable fee as a loan.
Because each provider may treat the fees differently, the underlying documents should be reviewed to see if the treatment as a loan is appropriate. In Finzer, for example, there was a promissory note and that note was to bear interest if there was a default in payment; the documents described the fee as a loan; and the provider testified that it considered the fee to be a loan.
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