IRS Issues Directive on Contractual Allowance Issues in Healthcare Industry

This memorandum provides direction to the field concerning efficient use of examination resources relating to the audit of contractual allowances, which have been designated a Tier II compliance issue. As a result of this designation, LMSB-wide coordination is required to ensure consistent disposition or resolution of the issue. Healthcare providers deal extensively with third-party payers such as insurance companies and government agencies. They maintain contracts with many third-party payers that result in a contractual obligation to accept a lesser amount than their standard charge as payment for goods or services provided. Billing reflects the standard charge, and contractual allowance accounts reduce reported accounts receivable to the contractually mandated amount. For accrual-basis taxpayers, the reduction to accounts receivable produces a parallel adjustment to income.

The computation of contractual allowances for book purposes follows generally accepted accounting principles (GAAP), and utilizes the concept of net realizable value (NRV). Contractual allowances determined for book purposes often do not provide a proper determination of taxable income. This directive and its related guidelines provide a uniform format and approach for examiners to evaluate potential compliance risk related to this issue; outline the established issue management and oversight process; and introduce an initial set of audit guidelines. This directive is not an official pronouncement of law or the position of the Service and cannot be used, or cited, or relied upon as such.

Background:

Description of Issue

The primary source of revenue for healthcare providers is remuneration for the provision of medical goods and services to patients. Providers typically issue multiple bills for the same services to the patient and any responsible third-party payer. Third-party payers include entities such as private insurance companies and government payers such as Medicare and Medicaid. Bills which generate "receivables" for accrual basis taxpayers are issued as soon after the patient is discharged as all services and costs can be captured.¹

Providers have a standard charge for each specific good sold or service rendered. The standard charge amount, reflected on all bills issued, is the amount initially recorded as an account receivable on the financial books when the service is rendered or the good is sold.² However, providers have contractual agreements with the vast majority of third-party payers regarding the amount that the payer will reimburse for specific goods and services (i.e., the contract provides for a discount for enumerated goods and services). The amount of discount typically differs in contracts between a provider and different payers and, in fact, often differs between different plans offered by the same payer. Thus, a provider typically receives different amounts from different payers in full satisfaction of claims for the same goods or services provided. While ultimate payment of the actual amount due comes from one or all of the sources to whom bills are issued, payment from all sources is dictated by the terms of the contractual agreements in force (i.e., the contractual agreements with a third-party payer or payers will govern the amount of payment by a patient).

Contractual allowance does not constitute bad debt, since the provider was never entitled to collect the difference under the terms of the relevant contract. A provider's book contractual allowance represents the difference between the amount recorded on its books as a receivable at the time of the initial billing and the estimated net realizable value (NRV) of gross receipts reported for book purposes under GAAP. NRV is not an acceptable method of determining income for tax purposes.

On the income tax return, properly determined contractual allowances would correctly offset gross receipts. The tax return may report either a net amount of receipts (already reduced for contractual allowances), or total billed amounts with an offsetting reduction for contractual allowances. The reduction will often appear in returns and allowances.

At the time each bill is issued, a provider has, at a minimum, all of the following information underlying each such bill:

Applicable Law and Guidance

IRC 451 & Reg. section 1.451-1(a)

Internal Revenue Code (IRC) section 451 provides rules for determining the taxable year of inclusion for items of gross income. Section 1.451-1(a) of the Income Tax Regulations provides that under an accrual method of accounting, income is includible in gross income in the taxable year in which the "all events" test is met. The two-prong all events test is met when (1) all the events have occurred that fix the right to receive the income, and (2) the amount thereof can be determined with reasonable accuracy. Under the first prong of the all events test, a fixed right to receive income occurs when (1) the required performance occurs, (2) payment is due, or (3) payment is made, whichever happens first. See Rev. Rul. 74-607, 1974-2 C.B. 149. When an amount of income is properly accrued on the basis of a reasonable estimate and the exact amount is subsequently determined, the difference, if any, shall be taken into account for the taxable year in which such determination is made.

TAM 200619020

TAM 200619020 addresses the contractual allowances of healthcare providers, and reaches the following conclusions:

An accrual basis taxpayer engaged in conducting a nursing home business entered into a contractual arrangement for Medicaid payments with state departments of health. The taxpayer received payments throughout the year under an interim rate based on the projected reasonable cost of providing patient care. The taxpayer was required to submit a cost report within 90 days after the end of the year reflecting actual costs incurred. For federal income tax purposes, the taxpayer accrued income based on the interim rates throughout the year. For over-billings, the taxpayer made an adjustment at year-end to decrease gross income by an estimate based on prior experience.

At the end of the taxable year, the taxpayer in the ruling had available all the information necessary to readily calculate the exact amount of its compensation under the contract and, consequently, the exact amount of any refund due the department. However, for administrative ease the taxpayer consistently used an estimate, rather than the actual data on hand, as a basis for accrual of its liability to make a refund. The taxpayer relied on a method of estimation based on its prior experience (i.e., a "historical method"). The revenue ruling determined that this method, which it termed an "estimate," was no more than an assumption, based on prior experience, that costs incurred in providing certain services during the taxable year had remained the same as related costs incurred in prior years. The revenue ruling determined that this method of estimation did not constitute a proper basis for accrual under the all-events test.

The revenue ruling holds that "Under an accrual method of accounting, since the actual amount is readily calculable from information on hand at the end of the taxable year (1) the taxpayer must deduct the actual amount (as reflected on the cost report) of the refund, and not an estimate, and (2) the actual amount (as reflected on the cost report) of the additional payment is includible in income in the taxable year in which the related services are performed, not in the taxable year of receipt."

Application of Legal Principles

TAM 200619020 allows the use of estimates to the extent the use of estimates results in gross income determined with "reasonable accuracy." Whether the contractual allowances reflected on the taxpayer's returns meet the "reasonable accuracy" standard is a question of fact to be determined by the field. The Taxpayer must show that the contractual amount used in preparing the return is "reasonably accurate."

Book Income Determined under GAAP

Taxpayers use various methods of estimating to determine the contractual allowance reflected on their books under GAAP. Many utilize the same method of determining contractual allowances for both book and tax purposes. The reasonable accuracy contemplated by the TAM must comply with the provisions of the Internal Revenue Code. The TAM explicitly defines the term "contractual allowance" for tax purposes. While certain estimating methods which account for items outside of that definition may attain a "reasonable accuracy" standard for book or other purposes, they are not proper for tax purposes.

Book determinations under GAAP are designed to arrive at an estimate of "NRV" and do not produce the "reasonable accuracy" required by the Internal Revenue Code and Income Tax Regulations for tax purposes. According to the Miller GAAP Guide, the allowance method (1) recognizes an estimate of uncollectible accounts even though the specific individual accounts cannot be identified, (2) accounts for loss contingencies, and (3) considers estimates for total uncollectible accounts (regardless of cause).

AICPA Audit and Accounting Guides provide:

Net patient service revenue is reported at estimated net realizable amounts from patients, third-party payers, and others for services rendered and include estimated retroactive revenue adjustments due to future audits, reviews, and investigations. Retroactive adjustments are considered in the recognition of revenue on an estimated basis in the period the related services are rendered, and such amounts are adjusted in future periods as adjustments become known or as years are no longer subject to such audits, reviews, and investigations.

Amounts that ultimately will be realized by an entity are dependent on a number of factors, many of which may be unknown at the time the estimate is first made. Further, even if two entities had exactly the same clinical and coding experience, amounts that each might realize could vary materially due to factors outside of their control (for example, differing application of payment rules by fiscal intermediaries, legal interpretations of courts, local enforcement initiatives, timeliness of reviews, and quality of documentation). As a result, because estimates are a matter of judgment and their ultimate accuracy depends on the outcome of future events, different entities in seemingly similar circumstances may develop materially different estimates. The auditor may conclude that both estimates are reasonable in light of the differing assumptions.³

The all-events test does not encompass future events, but rather, what was known or knowable at year-end. These GAAP definitions and components are outside the TAM definition of contractual allowance.

Estimates Based on Prior Experience

Taxpayers often base estimates on prior experience. Revenue Ruling 81-176 found estimates based on prior experience to be no more than assumptions that did not constitute a proper basis for accrual under the all events test.

Estimates Based on Total Collection Experience

Estimates based on total collection experience do not limit their consideration to those amounts not collected due to contractual provisions, but instead take into account all uncollected amounts, regardless of reason. Their results cannot meet the TAM definition of contractual allowance.

Some estimating methods based on total collection experience co-mingle contractual allowance and bad debt within the same computation. This is improper for tax purposes since bad debts must be computed based on the specific charge-off method of IRC section 166, or, where the proper election has been made, the nonaccrual experience method of IRC section 448(d)(5). Each of the allowable bad debt methods require a separate computation, and cannot be included in a proper computation of contractual allowance.

Specific Accounts and Contractual Provisions

Where the taxpayer determines contractual allowance amounts by reference to specific accounts and contractual provisions (sometimes referred to as "logging" or "modeling"),⁴ the method would appear to be reasonable on its face. We may test the method if we have reason to believe it does not produce reasonably accurate results, and it is important for the examiner to understand the processes and components used in such systems.

Strategic Importance:

Healthcare is one of the largest industries in the United States with estimated expenditures of over $2 trillion. Contractual allowances are a potential issue for any accrual basis taxpayer receiving payment from third-party payers who have contracted to pay less than the provider's standard charge. Contractual allowances often reduce the gross income of a healthcare provider by fifty percent or more.

The issue will be present in virtually all taxable (investor-owned) hospitals. Investor-owned hospitals represent 15-20% of a total hospital market with estimated receipts of approximately $700 billion. The issue will also be present in physician practices and other physician related companies that are not cash basis personal service corporations. In addition, the issue will appear in many ancillary healthcare market segments (home health, lab companies, etc.) where third-party payers pay less than a standard charge. Home health alone is a $50 billion plus segment of the market.

Issue Tracking:

Uniform Issue Listing (UIL) code 451.19-02 has been assigned to this issue. In addition, all examiners should use Secondary Standard Audit Index Number (SAIN) 320 in conjunction with the assigned UIL code.

Planning and Examination Guidance:

• Bill all goods and services at a standard charge

• Enter into contractual arrangements with payers (primarily third-party payers) to accept less than their standard charge in full payment of a bill

• Record income at the standard charge

• Utilize contractual allowances to reduce recorded income

• Book income is computed using GAAP/NRV and there is no M-3 adjustment

• Contractual allowances are determined by reference to:

• • Prior experience, and/or

  • Total collection experience

  • Co-mingled contractual allowance and bad debt amounts

• Any of the following components are included in the contractual allowance included on the income tax return:

• • Contingencies

  • Reserves

  • Subjective Judgments

• Contractual allowances are computed with reference to any patient account where:

• • There is no contract in force at the time services are rendered

  • The contract in force provides for full payment of the standard charge

Methods that limit results to contractual allowance as defined by TAM 200619020

In order to determine whether the contractual allowance amount on the income tax return is reasonably accurate, an examiner must first determine whether the taxpayer utilizes a method that limits its results to the clearly defined TAM definition of contractual allowance. This type of method would reference specific accounts and contractual terms or provisions. Where a method of this type is in use, an examiner may:

• Accept the method on its face

• Evaluate the method further if there are indications it does not produce a reasonably accurate result

• Examine factual or computational components to verify the correct application of an acceptable method

In contrast, where the taxpayer utilizes a method that does not limit its results to the defined TAM definition of contractual allowance, several examination steps may be required. Examples would be the use of a Book/GAAP/NRV method with no Schedule M-3 adjustment to correct the method for tax purposes, or any method that considers prior experience and/or total collection experience.

STEP 1 -- Determine Whether the Method Produces a Reasonably Accurate Result

The burden of proof rests solely with the taxpayer to demonstrate that the method used is reasonably accurate. A method may appear unreasonable by virtue of its reliance on NRV, prior experience, and total collection experience of other components which are outside the TAM's definition of contractual allowance. In this circumstance, a taxpayer may meet its burden of demonstrating a result consistent with that of a method that utilizes specific accounts and contractual provisions.

For book purposes, internal and external auditors often utilize various methods of review to consider, in hindsight, what should have been done. With regard to contractual allowances, these type reviews generally are not intended as a measure of whether accruals were proper under the terms of the contract or correct based on information available at period end. They typically utilize collection experience in order to conform to the financial accounting standard of NRV. External auditor testing is generally intended only to provide support to obtain reasonable assurance for an opinion as to whether the financial statements are free of material misstatement. Neither internal nor external reviews of this type typically support any statistically valid or measurable conclusion regarding the validity or accuracy of accruals, revenue, or accounts receivable. These methods of review do not automatically or necessarily verify the accuracy of income reported for tax purposes. The methods must be analyzed and verified in accordance with the TAM definition of "contractual allowance" in the same manner as the method under examination.

STEP 2 -- Removal of Impermissible Method Components

Many components of Book/GAAP methods are not proper for income tax purposes. The following examples illustrate the type of impermissible components that are often found in methods of accounting for contractual allowances

• Contingencies

• • Events that may occur in the future

  • Example: Accrual for potential results of potential audit by third-party payer

  • While often required for book purposes, contingencies may not be taken into account for tax purposes (Rev. Rul. 81-176)

• Reserves

• • Events that have occurred but are unknown to the taxpayer

  • Example: Errors, Corporate Office Accruals⁵

  • Reserves of this type are allowable for book purposes, but do not meet the all-events test of Reg. section 1.451-1

• Self-Pay / Medicaid Pending / Medicaid Unqualified

• • Uninsured patients billed for, and expected to pay, the full standard charge

  • Uninsured patient accounts unqualified or unapproved for Medicaid coverage

  • No third-party payer exists and no contract is in force at the time the services are provided

  • TAM requires existence of legally enforceable contract at the time the services are provided

• Commercial Insurance / Worker's Compensation

• • Patients insured by commercial third-party payers, such as auto insurers, where no contract is in force at the time the service is provided, or by worker's compensation

  • TAM requires existence, at the time the services are provided, of a legally enforceable contract that provides for less than full billed charges.

• Subjective "Judgment"

• • May appear at either facility⁶ or corporate level

  • May be based on management experience, historical information, current conditions, and other factors

  • May be identified by terms such as global or risk

  • Do not relate to a specific patient account or contract

The computation of a contractual allowance amount for accounts properly subject to reduction may be improper due to the use of NRV, unadjusted collection history, or other methods which do not limit their result to the TAM definition of "contractual allowance." The size and significance of the remaining amount, in both relative and absolute terms, and the egregiousness of the method will determine whether further examination is necessary. Where further examination is necessary, there are several potential methods of determining the proper contractual allowance amount.

The preferred method is the utilization of specific accounts and contractual provisions available to the taxpayer at the time services were performed or goods were provided. This information will typically be voluminous; however, computerization of billing, collection, and accounting processes should permit identification and categorization of such accounts, and provide many relevant details. Where the information is not available in the format required for proper testing or review, the examiner should consider the use of a statistical sample. In In addition, if the taxpayer is unwilling or unable to provide the billing expertise required to interpret the information, consider the use of an outside expert.

Where time and resources are limited, we can consider other available information:

• Online payment calculators provided by payers

• Commercial computer software maintained by the taxpayer

• Historical contract experience on a procedure-by-procedure basis (where contract provisions are relatively consistent)

• Identify ALL general ledger accounts that impact the contractual allowance computation for both book and tax

• Provide ALL workpapers and computations that show the computation of contractual allowance and the steps taken to arrive at book and tax amounts

• If the total Contractual Allowance for tax is different than that for book, identify the amount of the difference and provide the computation(s) for converting book to tax

• Identify the method used to arrive at the contractual allowance used on the tax return (e.g., historical estimate, modeling, specific item, etc.), and provide the formulas used in the computation with a detailed explanation of each component of the formula

• Provide the rationale for each component that makes up the total contractual amount for book and tax

• Identify the individual(s) in the company who has overall responsibility for Accounts Receivable management and Patient Account management

• Provide copies of ALL company internal accounting manuals and policy manuals where Contractual allowances are addressed

• Provide copies of ALL correspondence between the company and its outside auditors or tax advisors where contractual allowances are addressed

• Identify the person(s) in the company who had direct responsibility for the contractual allowance reflected on the tax return for year _____

• Identify contingencies that are a part of the total contractual computation

² The actual bill very often includes charges for both goods and services. Throughout this directive, reference to services rendered includes any goods provided or sold.

³ Audit and Accounting Guides AAG Health Care Organizations Chapter 1 -- Unique Considerations of Health Care Organizations AICPA AAG HCO

Appendix E -- Statement of Position 00-1 Auditing Health Care Third-Party Revenues and Related Receivables

⁴ "Logging" and "Modeling" are among the terms applied to the electronic application of specific contractual provisions to patient account gross billings based on a matching of responsible third-party payer, patient coverage, and the nature of goods and services provided.

⁵ Additions determined at the corporate office level that do not relate to specific facilities or accounts.

⁶ Where a healthcare corporation operates one or more facilities, some billing and collection functions may be performed by the facilities themselves. Thus, in addition to corporate level judgments, certain judgments may be made at the facility level by facility personnel.