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. …