By Russell G. Roll, J.D., C.P.A.
Those who read a recent Medical Economics article by Martin A. Goldberg, J.D., “Get Ready for the IRS’s Newest Doctor Shakedown,” may have asked themselves whether the IRS was joking with its plan to tax your receivables. Unfortunately, and as some practitioners have learned the hard way, the IRS is not joking.
In what appears to have been an ill-conceived pilot program initiated in western Pennsylvania, an office of the IRS made a sweeping attempt to convert physicians’ income tax returns from the traditional cash method of accounting to the accrual method. Although in each known instance the IRS was ultimately unsuccessful, the Service has not given up the fight. As Mr. Goldberg notes, the subject will be addressed specifically in a Market Segment Specialization Program (MSSP) Audit Guideline by the IRS as part of its campaign, which is yet-to-be-released.
For some time, the IRS has been chomping at the bit at the thought of collecting tax dollars from the medical community as quickly as possible, on income before it is even collected. While the IRS’s stated reason for this campaign has been based upon the Internal Revenue Code’s requirement that the accounting method used by a taxpayer must clearly reflect income, the motivation is probably much less noble; accelerating the taxability of receivables accelerates the collection of tax dollars.
You can safely assume that the cost associated with changing (or being forced to change) to the accrual method will mean paying taxes earlier. For example, in a year where receivables increase, due either to increased production or to slower payment on the part of insurance providers or patients, or both, you will pay additional income taxes on the increase in receivables in that year.
As you can imagine, paying taxes on money which has not been received can cause some serious cash flow problems. Moreover, paying taxes earlier as opposed to later takes away the potential of additional investment earnings.
And what if the IRS forces this change after the fact? Get ready for a potentially high tax bill. If your practice operates in a corporate form, the corporation will pay the additional taxes, at a flat rate of 35 percent. This is the same income that you probably received in the year following the change, as compensation, resulting in taxes on your personal return. The end result—your receivables will be taxed twice; once at the corporate level (35 percent), and once at your personal level (up to 39.6 percent). All tolled, you will most certainly have paid more than your fair share.
How is the IRS Justifying It?
As mentioned earlier, the IRS’s stated motivation behind this campaign is the requirement that a taxpayer’s accounting method must clearly reflect income. As one can imagine, such a phrase is not susceptible of one clear interpretation, and is therefore the subject of much regulation on the part of the IRS, and litigation on the part of taxpayers. The issue has been raised since the very beginnings of the Internal Revenue Code, and will in all likelihood continue throughout the life of the Code as we know it.
There is no requirement that a taxpayer use an accounting method that most clearly reflects income. In fact, the cash method of accounting is specifically approved for certain taxpayers, and required for others.
In the corporate setting, the Internal Revenue Code specifically addresses which corporations may and may not use the cash method of accounting. The Code provides that as a general rule, corporations must use the accrual method, except as otherwise provided. There is a specific exception to this mandate in the case of a qualifying personal service corporation (PSC), i.e., a corporation which, through its employee-owners, provides certain enumerated services, including the practice of medicine.
The inquiry should end there, right? Not so, according to the IRS. Under another provision of the Code, taxpayers who maintain inventory must use the accrual method of accounting, and, according to the IRS, this mandate overrides the exception for PSCs. Therefore, medical practitioners must use the accrual method to report income, since they maintain inventory in the form of prescription drugs, serums, bandages, etc.
Here lies the true disagreement between the IRS and the taxpaying public. If a PSC that could otherwise use the cash method maintains inventory, does the law require the PSC to switch to the accrual method? More importantly, what does it mean factually to maintain inventory?
The answer to the first question can be found in temporary regulations issued by the IRS in 1986, and not yet made final. Under Treasury Regulation 1.448-1T(c), the inventory/accrual requirement supersedes a PSC’s ability to use the cash method. Therefore, barring any judicial test as to the validity of the regulation, the true question is when must a taxpayer maintain inventory.
As a general rule, a taxpayer is required to maintain inventory on its books for tax purposes when the taxpayer produces income from the manufacture or purchase, and later sale, of merchandise. Under the Code, no method of accounting other than the accrual method will result in a clear reflection of income derived from the sale of inventory. The cash method would result in a mismatching of revenues and expenses in different years (i.e., expenses in earlier years when inventory is purchased, and revenues in later ones when it is sold), since, as common sense would suggest, inventory is normally purchased before it is sold.
But how does this apply to medical care providers? The non-service aspect of the physicians’ business (i.e., dispensing occasional medications, bandages, crutches, etc.), more often as a courtesy or out of necessity, is viewed by the IRS as a purchase and later sale of merchandise. The fact that this component is small in comparison to the practice’s overall revenues is not necessarily controlling, although it certainly can be helpful in defending against an IRS attack.
There is a distinction between merchandise maintained by physicians, which drags the practice into the IRS’s lair, and supplies, which even according to the IRS need not be maintained as inventory. Simply put, if everything consumable in the office could be characterized as a supply instead of merchandise, there would be no need to maintain an inventory for tax purposes, and presumably, no need for a switch (or to be switched) to the accrual method.
Supplies are items consumed during the process of providing services. Merchandise, on the other hand, is distributed to the patient during the process of providing services. A clear line in some ways, but not so clear in others.
In a traditional business setting, it is usually easy to distinguish supplies from merchandise under the above definitions. However, when focusing on the medical community, the lines become blurred. This is especially the case in the areas of oncology, urology and ophthalmology, where what might be viewed universally in the medical community as supplies are viewed as, you guessed it, merchandise, by the IRS.
Is There Any Hope?
Whether the IRS will abandon this project is anyone’s guess. However, assuming it does not, there is some hope for physicians who are presently maintaining their tax records on a cash basis.
In fact, a branch of the IRS recently ruled in favor of the taxpayer in such a situation. In Technical Advice Memorandum 9723006 (the TAM, dated February 7, 1997), the National Office of the IRS considered the question for a group of physicians who operated a medical clinic on the cash basis. In this case, the clinic was unable to differentiate between supplies (such as disposable syringes and rubber gloves) and merchandise (again, medicines, serums and bandages); however, the clinic was able to show that the total merchandise and supplies for the years in question amounted to approximately 8 percent of the clinic’s revenues.
The National Office noted that the PSC in question had consistently reported its income using the cash method of accounting, that the PSC had never attempted to manipulate the results achieved using that method and that the cash method clearly reflected income. The examination division of the IRS, on the other hand, maintained that the accrual method it proposed would more clearly reflect income. The National Office concluded that the merchandise was in any event de minimis, and that the taxpayer was therefore not required to maintain inventory on its books for tax purposes. Having concluded that there was no need on the part of the taxpayer to maintain inventory on its books for tax purposes because of its de minimis nature, the National Office summarily rejected the examination division’s position, stating that “the [IRS] cannot require a taxpayer to change from a method of accounting that clearly reflects the taxpayer’s income to an alternative method of accounting merely because the [IRS] believes that the alternate method more clearly reflects the taxpayer’s income.”
This TAM is somewhat of a victory for taxpayers, although the extent of the victory is unclear. In the event the examination division of the IRS chooses to continue its approach on the subject, taxpayers may still face the task of struggling through an examination and subsequent appeal procedure in order to end up where they began, so to speak. No taxes, just accounting and legal fees.
Still, the TAM does give some strong guidance on what steps may be taken to ultimately prevail on the issue. For example, the National Office placed weight on the fact that the PSC in question had never attempted to manipulate the results achieved using the cash method. Presumably, year end “tax planning strategies”, such as withholding deposits for the last week of the year, and delaying year end billings (all of which are easily identifiable by the IRS), should be avoided. Keeping the use of items which may be classified as merchandise to a minimum would also support a de minimus finding such as that announced in the TAM.
Finally, while not addressed in the TAM itself, having as few items on hand at the end of the tax year which may be classified as merchandise should further support a cash basis method, since presumably, relatively small year-end inventories would indicate a relatively small tax cost to the government associated with the use of a cash method.
There may also be hope in removing accounts receivable from the IRS’s plate by employing what is known in the tax profession as a “hybrid” accounting method. Under such a method, income from professional services may be reported under the cash method. The income and expenses from ancillary activities, such as providing the merchandise to patients, may be reported under the accrual method.
The result of such a hybrid method, if accepted by the IRS, would be that receivables are not taxed until collected, thereby avoiding the majority of the cash flow problems which would be caused by the accrual method. At the same time, the merchandise would be deductible in the year used, and not in the year purchased. The hybrid method represents a compromise between the traditional taxpayer’s side and the IRS’s.
The hybrid method is specifically approved in the Code and by the IRS. While the IRS has apparently attempted to withdraw its approval of the hybrid method in the health care segment of the taxpaying population, this attempt was met with disfavor in the Tax Court. However, professional guidance is strongly recommended before converting an existing practice from the cash method to a hybrid method in a preemptive strike against the IRS’s present undertaking for a variety of reasons.
First, changing from one method of accounting to another for income tax purposes generally requires prior approval by the IRS. In addition, while the Tax Court has sided with the taxpayer in the use of a hybrid method in the health care setting, that does not necessarily mean that the IRS has given up the fight. Quite simply, the Tax Court left the door wide open for future litigation on the part of the IRS in cases where the hybrid method is perceived to be used in an abusive fashion, i.e., substantial prepayment of ordinary expenses which are deducted under the hybrid method, but which would have been deductible later under the accrual method. This situation demonstrates the general principle of life that too much of a good thing can be harmful to a taxpayer’s financial health.
Tax advisors are anxiously awaiting the issuance of the IRS’s health care MSSP Audit Guidelines, which should give some insight into the other potential issues facing the medical community specifically. It is widely believed that the Guidelines will identify methods by which unreported revenues may be identified, particularly categories of expenses for closer scrutiny during audit, and unreasonably high compensation to shareholder/employees.
Russell G. Roll, J.D., C.P.A., is a tax attorney with the law firm of Kabala & Geeseman, a Pittsburgh law firm.