Income from incidental supplies does not bar a service provider from using the nonaccrual experience method.
Nonaccrual Experience Method
Sec. 448(d)(5) allows an accrual-basis service provider to avoid accruing income on the portion of its receivables estimated to be uncollectible, based on the provider's experience. The method is not available if the taxpayer charges interest or late payment penalties. Sec. 448(d)(5) was enacted by the Tax Reform Act of 1986, in connection with restrictions placed on the use of the cash method for many corporations. Temp. Regs. Sec. 1.448-2T was issued in June 1987 and amended 10 months later.
The portion of receivables estimated to be uncollectible is generally based on a six-year moving average of the taxpayer's actual bad debts and receivables. The ratio of accounts receivable estimated to be uncollectible is applied to the service provider's outstanding receivable, using either the "separate receivable system" or the "periodic system."
Under the separate receivable system, the ratio is applied to each receivable outstanding at year-end; that portion of the receivable is neither recognized as income nor added to basis. If the amount later collected on the receivable is greater than the basis, the excess is recognized as income in the year of collection. If the ultimate amount collected is less than the basis, the difference between the receivable's basis and the amount collected is a bad debt deduction.
Under the periodic system, the taxpayer establishes a bad-debt reserve account based on the ratio multiplied by the amount of the outstanding receivables. The basis of each receivable is not affected. The reserve account is adjusted periodically for recoveries and write-offs, and the corresponding increase or decrease to the account balance is taken into account in determining taxable income for the period.
If there is a change in the type of accounts receivable a taxpayer accrues, such that the risk of loss is substantially increased, a taxpayer may request the IRS's approval to use a period shorter than six years. A taxpayer in existence for less than six years would base its experience ratio on the years it has existed, through the current year. If there was a predecessor trade or business for some of the six years, the predecessor's experience would be used in determining the ratio.
Hospital Corp. of America
Hospital Corp. of America and its subsidiaries owned, operated and managed hospitals and related businesses. The taxpayers elected in 1987 to adopt the nonaccrual experience method, using the periodic system, to estimate the portion of each hospital's income that would not be collected. The Service disallowed all reductions in income attributable to the use of the nonaccrual experience method, other than net write-offs of bad debts, on two grounds. First, the IRS determined that the hospitals had not separated the portion of the income earned from the performance of services from the portion of income earned from the sale of medical and surgical supplies and pharmaceutical items; the Service contended that the income from the sale of medical supplies was ineligible for the nonaccrual experience method. Second, the IRS determined that each hospital had used the formula for determining its uncollectible experience ratio set forth in Temp. Regs. Sec. 1.448-2T(e)(2)(i) as originally issued, rather than the formula set forth in the amended regulation.
Eligibility of Supply Income
The Service contended that the taxpayer derived income from the sale of medical supplies, and that such income was not eligible for the nonaccrual experience method. Because the taxpayer could not segregate income earned from the sale of medical services from income earned from the sale of medical supplies, the IRS argued that the taxpayer could not use the nonaccrual experience method for any portion of its income. The taxpayer argued that the use of medical and surgical supplies and pharmaceutical products was an integral part of the treatment a patient would receive at a hospital; it was the medical treatment and not the medical supplies that patients sought from the hospital. Further, the taxpayer noted, under the payment arrangements between the hospitals and public and private insurers, the hospital bills given to patients generally bear no particular relationship to the amounts the hospitals would actually be paid for the services provided. The court agreed with the taxpayer that the medical supplies furnished in the course of rendering medical services were inseparably connected to the performance of those services, even though they were significant in amount. Therefore, income attributable to medical supplies constituted income earned from the performance of services within the meaning of Sec. 448(d)(5).
Uncollectible Formula Corrected
Sec. 448(d)(5) provides that an accrual-basis service provider does not have to accrue income for amounts which, "on the basis of experience," will not be collected. The court found this statutory language to be unclear. The legislative history to Sec. 448(d)(5) did not clearly state any specific formula that Congress intended for this purpose, but did suggest a preference for a fixed formula for calculating the uncollectible amount. Under Temp. Regs. Sec. 1.448(d)(5)-2T(e)(i), the uncollectible amount of receivables is determined by multiplying the amount of outstanding receivables by an experience ratio. In the original regulation, the ratio was determined by calculating the total bad debts with respect to accounts receivable sustained during the current tax year and five preceding tax years, less recoveries of bad debts during that period, and dividing it by the sum of the accounts receivable at year-end over the same six-year period. The amended regulation changed the denominator of the ratio from the sum of the accounts receivable balances at the end of each of the six years to the sum of the accounts receivable earned (i.e., total sales), for the same six years. The court ruled that the amended regulation was a permissible interpretation of the statute; therefore, the Service could require the taxpayer to use the formula set forth in the amended regulation, which the taxpayer had not done.
Opportunities for Service Providers
The nonaccrual experience method is available for all service providers and is not limited to "personal service" providers (i.e., in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, etc.). Examples of other qualified service businesses include travel services, data processing, telecommunications (e.g., phone cards), cable companies, utilities, management services, credit reporting services, temporary help agencies, entertainment services, publishing, restoration, repair, painting and other general contracting services, airline, trucking and other transportation businesses. Based on the Tax Court's decision in Hospital Corp. of America, the provision of parts or supplies incidental to the performance of services will not disqualify the taxpayer from using the nonaccrual experience method for the entire amount due from the customers.
A new taxpayer may adopt the nonaccrual experience method in its first tax year by filing its tax return using that method. A corporation required to change its overall accounting method from cash to accrual under Temp. Regs. Sec. 1.448-1T(h)(2) (i.e., on meeting the $5 million gross receipts test) may automatically change its method of accounting to the nonaccrual experience method at the same time, under Temp. Regs. Sec. 1.4482T(h)(2), if it qualifies to use that method. The automatic change applies only to taxpayers that change to the accrual method in the first tax year they are subject to Sec. 448. Other taxpayers wishing to change to the nonaccrual experience method must request permission from the IRS National Office by filing Form 3115, Application for Change in Accounting Method. Generally, Form 3115 is due within 180 days from the beginning of the tax year of change.
From Carol Conjura, CPA, J.D., and Pauline Mak, CPA, Washington, D.C.
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|Publication:||The Tax Adviser|
|Date:||Jun 1, 1997|
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