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 to 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-Care 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

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 businesses 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 ***.

In the Declaration, petitioner agreed to divide the subject property into 16 "legally described freehold estates" consisting of the 16 condominium units and one freehold estate consisting of the common area. Paragraph 21.5 of the Declaration states:

Leasing or renting of Unit is not prohibited; provided, however, that so long as *** [petitioner] owns or control (sic) the Highland Farms Retire

ment Complex, prospective tenants must first be approved by *** [petitioner] for suitability within the Highland Farms Complex, which approval shall not be unreasonably withheld.

Petitioner filed an amendment to the Declaration on December 31, 1987, adding more units and area to the condominium.

As of June 27, 1991, the overall average length of occupancy of an apartment unit by a particular resident was 5 years, 2 months.8 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 December 15, 1990, but accounting changes made so as to conform

8 The average length of occupancy for each unit was calculated, and then the overall average length of occupancy for all units was calculated.

9 See supra note 8.

10 This data was compiled using the residents at the time of the analysis, sometime in mid1991.

11 See supra note 10. This sample was drawn by taking each eighth account beginning with the eighth account.

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 Nos. 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 No. 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 No. 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 No. 261 had a balance of $578,038, and account No. 262 had a balance of $1,066,982, for a total of $1,645,020. As of December 31, 1988, account No. 261 had a balance of $628,577, and account No. 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 "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.

Respondent 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 & 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 adjustment 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.