Physician Practices and Proper Accounting Methods

Rev. Proc. 2000-22 and the Tax Court's decision in Osteopathic Medical Oncology and Hematology, P.C., 113 TC 376 (1999), provide a clearer understanding in advising physician practices on adopting correct accounting methods. Rev. Proc. 2000-22 permits most taxpayers with $1 million or less in average annual gross receipts to elect out of the requirement to account for inventories or use the accrual method of accounting for purchases and sales of merchandise. (For a discussion, see Hesse, "Rev. Proc. 2000-22 Allows Certain Taxpayers to Use Cash Method," p. 870, this issue.) In Osteopathic Medical Oncology and Hematology, P.C., the Tax Court found that drugs administered by a medical practice as an indispensable part of its services were not "merchandise" under Regs. Sec. 1.471-1. The result was that the practice correctly maintained its books and records on the cash method for tax purposes.

Cash vs. Accrual Accounting Methods

The obvious advantage of a medical practice electing the cash method is deferral of income until revenue is collected. Taxpayers generally elect this accounting method on a timely filed initial return. Only the IRS can grant permission for a taxpayer to change from the accrual to the cash method. The Service almost never gives permission to change to the cash method, because it views the accrual method as a better means of accurately matching income and expenses.

Sec. 448 limits which entities may use the cash method. C corporations, partnerships with C corporations as partners, tax shelters or unrelated trade or business activities of tax-exempt organizations generally cannot use the cash method; see Sec. 448 and Temp. Regs. Sec. 1.448-1T. Conversely, sole proprietorships, partnerships with no C corporation partners and S corporations are allowed to use the cash method. Occasionally, the IRS grants exceptions to C corporations (provided the average annual gross receipts are less than $5 million), qualified personal service corporations (as defined under Sec. 448(d)(2)) and farming businesses.

The Service may deny the use of the cash method, if it "does not clearly reflect income" (Sec. 446(b)). One example of a "clear reflection of income" is an entity deemed to have an inventory. In an attempt to match income with expenses, the IRS would mandate a change to the accrual method.

Denial of Cash Method when Inventory Is Present

Inventories/accrual method requirement. Sec. 471 and Regs. Sec. 1.471-1 provide that inventories are necessary in every case in which the production, purchase or sale of merchandise is an income-producing factor. Under Regs. Sec. 1.466-1(c)(2), businesses with inventories must use the accrual method.

Materials or supplies recorded as a prepaid expense. Sometimes, materials or supplies must be recorded as prepaid expenses. Under Regs. Sec. 1.162-3, taxpayers with materials and supplies on-hand should include their cost in expenses, but only to the extent the materials and supplies are actually consumed and used in operations during a tax year. The material or supplies may be expensed as purchased by a cash-method taxpayer, if all four of the following criteria are met:

1. Materials or supplies are incidental;

2. No record of consumption is kept;

3. Physical inventories at the beginning and end of the year are not taken; and

4. This method clearly reflects income.

Rev. Proc. 2000-22 allows an exception to the general rule that all entities with inventories must use the accrual method. Under this revenue procedure, the Service excludes "eligible small taxpayers" from the mandate to use the accrual method, provided they treat merchandise inventory in the same manner that a cash-method taxpayer handles material or supplies not incidental under Regs. Sec. 1.162-3.

The IRS defines an eligible small taxpayer as an entity that has average annual gross receipts of $1 million or less and does not regularly use a noncash method of accounting for books, records and reports. A taxpayer has average annual gross receipts of $1 million or less if the average gross receipts for the three prior tax years (ending with the applicable prior tax year) do not exceed $1 million. Once a taxpayer exceeds the limit on the average-gross-receipts test, it must change to the accrual method.

If a taxpayer meets the average-gross-receipts threshold, it can use the cash method to record income and expenses, and defer income. However, the taxpayer would have to defer the expense of purchases (whether paid or not) until it records revenue, to better match income and expenses.

Osteopathic Medical Oncology and Hematology, P.C.

In Osteopathic, the Service asserted that chemotherapy drugs were an item of significant value in relation to the business's overall revenue that warranted classification as inventory. It mandated that Osteopathic use the accrual method, and assessed a deficiency on accounts receivable in excess of accounts payable on the sale of chemotherapy drugs. The IRS also made an adjustment for inventory at the fiscal year-end.

The Tax Court decided in the taxpayer's favor and allowed it to continue to use the cash method. The decision turned on one issue, with a majority concurring that chemotherapy drugs were an integral part of the overall service provided by Osteopathic. Therefore, the court did not treat the drugs as merchandise for resale, but as an inseparable part of the practice's overall service. The Tax Court examined the method of dispensing and administering the drugs to determine that they were part of an overall plan of medical treatment authorized and administered by the same physician that purchased the drug.

Osteopathic provides an understanding of how the courts interpret the Code and regulations in the areas of inventories and prepaid assets (e.g., materials or supplies). The court pointed out that the Service erred by not declaring the drugs material or supplies under Regs. Sec. 1.162-3. Given this, the value of the drugs would have certainly been considered a prepaid expense. Further, a dissenting opinion made a strong argument for treating the chemotherapy drugs as inventory. Tax advisers should use caution and examine a client's specific facts before relying on Osteopathic to support a recommendation.

Hybrid Accounting Methods

Sometimes, two separate and distinct lines of businesses may exist within the same tax entity. This has occurred more often with the passing of the Stark laws and regulations. Under Stark I and II and the regulations, physicians that bill Medicare or Medicaid are limited in the ability to self-refer and share in profits through incentive plans. More and more physician groups are combining services into one taxpaying entity to allow some flexibility in compensation. For example, it has become more common to have physician practices, laboratories and x-ray operations under one roof (e.g., optometrists or ophthalmologists teaming up with a vision eyewear business owned by the same principals). Under Regs. Sec. 1.446-1, taxpayers that keep separate and complete books and records for each trade or business may use both the cash and accrual methods of accounting (e.g., optometry and vision eyewear businesses can maintain a hybrid method--the cash method for the optometry practice and the accrual method (maintaining inventory) for the eyewear business).

Conclusion

When advising physician practices, tax advisers must be aware of all possible options to defer income and accelerate expenses. It is important to understand who is eligible to use the cash method, when inventories are required and when materials or supplies must be recorded as prepaid expenses. Osteopathic has given tax advisers new insight into what comprises inventory and material or supplies.

From Kevin E. Hines, CPA, MST, Meyers Brothers, P.C., Longmeadow, MA