Wall Street Journal, Retirement-Community Operator Battles IRS Over Entrance Fees, by John R. Emshwiller:

Classic Residence by Hyatt, a group of businesses that run upscale retirement communities, is battling the IRS over allegations it underpaid its taxes by more than $107 million, in a dispute over the tax treatment of entrance fees paid by incoming residents.

The issue boils down to whether the entrance fees qualify as taxable income, as the IRS asserts, or interest-free loans, as Classic Residence argues. Other retirement communities charge similar fees. …

Classic Residence communities are set up to provide their residents with increasing levels of care, including skilled nursing services, as they grow more infirm. Entrance fees can range from the low six figures to more than $2 million per person, depending on the size and amenities of the living unit involved.

Besides the more than $107 million in alleged back taxes, the IRS is seeking more than $21 million in penalties from Classic Residence related to "negligence or intentional disregard of rules…or substantial understatement" of income, according to a Dec. 30, 2009, notice the agency sent to operators of the communities. The IRS contends that the venture under-reported income by more than $300 million in 2005 alone.

Tax experts say the outcome of the case could affect other operators of for-profit retirement communities. …

In court filings, Classic Residence attorneys say that a substantial portion of the entrance fee—in many cases at least 90%—is refundable when a resident leaves or dies; therefore, they say, the refundable portions should be treated as interest-free loans to the residence operator. As such, the filings add, the fees wouldn't be taxable as income.

Classic Residence's attorneys also say that by trying to classify the fees as income the IRS is reversing past positions. The agency "has concluded on several occasions" that the refundable part of "an entrance fee is properly characterized as a loan," according to one filing.

In its Dec. 30 tax-deficiency notice, the IRS said it "determined that entrance fees constitute income from rental/occupancy of the living units, and as such, must be included in income in the year received."

Given the federal government's huge revenue needs, the IRS is interpreting tax laws more aggressively, says David L. Rice, a Los Angeles tax attorney and incoming chairman of the American Bar Association's Individual and Family Tax Committee. The IRS's previous treatment of entrance fees as interest-free loans leaves it facing "a tough road" in the Classic Residence dispute, says Mr. Rice, who isn't involved in the case.

However, Mr. Rice adds that some aspects of the Classic Residence entrance fees might lead the U.S. Tax Court to agree with the IRS. To the degree entrance fees help hold down residents' monthly living charges, the payments could be viewed as a form of prepaid rent, which the IRS treats as income, he says. Plus, the residence operator has free use of the funds, sometimes for 20 to 30 years. So, "technically, it might look like a loan, but from the IRS's perspective, it smells like income," he says.

(Hat Tip: Jeffrey Barry.)

Update:  For the Tax Court petition, see here.