Experience rating your receivables.
One basic but important issue is the entity's method of accounting. Traditionally, medical practices have elected the cash basis of accounting. They have relied on the exception to the accrualbasis requirements for qualified personal service corporations (QPSCs) provided by Sec. 448(b)(2) or the exception for entities with average gross receipts for the last three years of not more than $5 million provided by Sec. 448(b)(3) to avoid the accrual method.
A QPSC, for this purpose, is defined in Sec. 448(d)(2) and the accompanying regulations as a service organization that meets both the "function" and "ownership" tests. To qualify as a PSC, the corporation must provide services in one of eight qualifying fields, and at least 95% of the stock must be owned by current employees who perform personal services for the corporation or retired employees (or their estates). Nonprofessional service businesses provide services outside of the eight qualifying fields and fail the function test. Many new medical practices are structured in a way that fails the ownership test. From a tax planning standpoint, these non-PSC medical practices are now the equivalent of nonprofessional service businesses, and cannot rely on Sec. 448(b)(2) to be able to use the cash basis of accounting.
Newly formed medical ventures tend to be larger in size and many include some ownership by a hospital. By virtue of these things, many of them will have gross receipts in excess of $5 million and will not fit into the small business exception of Sec. 448(b)(2) or (c).
Without an exception available to the general rule of Sec. 448(a), many service businesses may be forced to use the accrual method. Given the level of receivables service providers maintain, this could be a significant tax burden. The problem is exacerbated in medical practices by the fact that the receivables from third-party payers will generally be collected at a lesser amount than the total charge. The difference is referred to as a contractual adjustment and represents the difference between the amount a practice charges for a service and the amount the insurance contract allows for the same service. Under the general rules for bad debt deduction of Sec. 166, the deductible amount will be determined by the specific charge-off method. The result is that the recognition of income is accelerated. Sec. 448(d)(5) may provide at least partial relief. A special rule for amounts to be received for the performance of services allows for the exclusion from income of any amounts that, based on experience, will not be collected.
Temp. Regs. Sec. 1.448-2T(b) describes the nonaccrual-experience method and a specific formula for determining uncollectible amounts. This method of accounting is available only for amounts earned by the taxpayer and otherwise recognized in income by the taxpayer's performance of services. However, the nonaccrual-experience method does not apply if the taxpayer charges interest or a penalty for failure to make a timely payment. The offering of a discount for early payment of an amount due will not be regarded as the charging of interest or penalties if the full amount is otherwise accrued as gross income by the taxpayer at the time services are provided and the discount for early payment is treated as an adjustment to gross income in the year of payment, if payment is received within the time required for the discount.
The calculation of the portion of the receivables not expected to be collected is based on a moving average based on past experience. For any tax year, the uncollectible amount of a receivable is the amount that bears the same ratio to the account receivable outstanding at the close of the tax year as (1) the total bad debts with respect to accounts receivable sustained during the period consisting of the tax year and the five preceding tax years, adjusted for recoveries of bad debts during such period and (2) the sum of the accounts receivable earned throughout the entire six-year period.
The nonaccrual-experience method is applied to each of the taxpayer's accounts receivable eligible for such method. The estimated uncollectible amount of each receivable is not recognized as gross income. However, the collection of income that was not expected to be collected will generate additional gross income in the year collected. No bad debt deduction under Sec. 166 is allowed for an account receivable to the extent such amount was not previously reported as income under the nonaccrual-experience method.
As an alternative to the separate receivable system, taxpayers may use a periodic system (as described in Notice 88-51). The periodic system resembles a reserve method. The taxpayer maintains an allowance for uncollectible amounts that represents the aggregate amount that the taxpayer estimates will not be collected with respect to all of its accounts receivable in each trade or business. The estimate of uncollectible receivables is determined by the six-year moving average method described in the separate receivable system. The allowance is adjusted at year-end and the corresponding increase or decrease is made to gross income.
Any business with a service component that cannot use the cash method of accounting should consider the nonaccrual-experience method. This would constitute a change in accounting method and must be done within the guidelines of Temp. Regs. Sec. 1.448-2T(b). While automatic approval will be granted to taxpayers forced to change to the overall accrual method, taxpayers already using the accrual method need to request permission.
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|Author:||Krantz, Kevin M.|
|Publication:||The Tax Adviser|
|Date:||Aug 1, 1995|
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