IRS preparing to throw docs new audit curveball
Private practices will be hit the hardest
Internal Revenue Service. The initials IRS can send chills down the spines of many. But for physicians, administrators and other members of private practices nationwide, the word could become even scarier. That’s because of something called MSSP — shorthand for Market Segment Specialization Program.Created several years ago by the tax agency, this harmless-sounding initiative uses experts in an industry to analyze its characteristics and business practices. Then, the IRS publishes guidelines that help its examiners cut to the heart of audit issues or go for the jugular, so to speak.
Although the MSSP has hit a lot of professions over the years, physicians have been spared — until now. In 1997 the IRS published an MSSP guide focusing on the health care industry, largely aimed at doctors in private practice.
Since the IRS is doing its homework, practices and hospitals should do theirs. By finding out what’s in the guide, practices can avoid some of the tax agency’s hot spots. And, if a practice must venture into a sensitive area, knowing what the IRS is looking for will help mount the best possible defense.
Though the MSSP audit guide for the health care field is available, it’s still in draft form. But with some guidance from John Tucker, an industry specialist for the MSSP, we’ve pieced together a sneak preview of what you can expect in the IRS audit of the future, based on the IRS’ health care industry training manual. It’s not a pretty picture.
The MSSP guidelines detail how income is received from patients, indemnity third-party payers, fee-based HMO contracts, and capitated contracts. Agents will be told to compare day sheets with income statements to verify that every penny is accounted for.
Moreover, the person examining the tax return will know plenty about managed care. The examiner will understand what a withhold in a capitated contract is, for example, and if practices are paid a portion of it, he or she will want to know where they are reporting that money. If that income was included with some other payment, make sure the examiner can see it clearly.
There is more. Suppose an HMO owes a practice money for patient care, but instead of paying them, it simply credits the amount to an account in its name. Under the law, it must pay tax on the credit even though it hasn’t received or deposited a payment. And the audit guide instructs examiners to review all such arrangements.
Managed care income isn’t the only revenue the IRS will scrutinize. It will bear down hard on year-end procedures to see whether you delay filing claims until the beginning of the following year. Although no law requires practices to bill at any particular time, delayed billing will be a sign to an examiner that they may be improperly deferring income in other ways.
For instance, auditors will look at the receivables over several years to see whether they increase at year-end. If they do, it could be taken as evidence that practices are holding onto checks to defer income to the next year. That’s illegal, so if the practice receivables increase at year-end, make sure a legitimate explanation can be given.
Agents will also watch for overpayments resulting from multiple payers, and they’ll be suspicious if practices claim they are never overpaid. Although overpayments may be infrequent, you must be prepared to explain how the practice handles them, how they are recorded and deposited, whether or how they’re returned, and how they are reported for tax purposes.
If you can’t provide this information and show examples of how overpayments are handled, the IRS agent could intensify the examination. The agent could also shift the audit’s focus from the practice to you personally.
If the practice is incorporated, it can deduct a physician’s salary, but only to the extent that the compensation is reasonable. Until now, most doctors in private practice haven’t had to worry about this. That’s because in most cases they receive income only for their services. It’s hard for the IRS to argue the unreasonableness of such pay.
The upcoming audit guide makes it clear that the agency isn’t giving up on this issue, however. And physicians could be vulnerable.
For instance, the difficulty of claiming unreasonable compensation applies only to doctors, not their employees. The IRS proudly points to one of its victories against a medical practice, where the salary challenged as unreasonable was paid to the physician’s wife.
Fringe benefits are another target area
The IRS also focuses on fringe benefits, to see whether disguised profits were distributed to a doctor. Although all fringes are subject to audit, the IRS will concentrate on those that look like a dividend (a distribution of profits that the corporation can’t deduct).For example, if the practice lends an employee money but does not respect the formalities of a real loan, the IRS may try to treat it as a dividend. Ditto for other transactions that offer a special benefit, such as when the corporation rents property from employees and pays more than the going rate. The same applies to any expenditure by the corporation for personal benefits, such as paying a doctor’s family credit-card bill. If the practice uses corporate property or your office staff for personal purposes, these could also be considered dividends taxable to you and non-deductible by the corporation.
Although the IRS traditionally examines travel and entertainment and related expenses, it now will give them closer scrutiny.
Employees of the practice probably don’t spend much time thinking about their car phones. IRS agents will. They’ll be instructed to request evidence of how often the phones are used for personal purposes. Claiming no such use would probably be like claiming no overpayments are received. You’re better off coming up with an allocation that is defensible and seems reasonable.
This doesn’t mean they have to log every call. However, if a log is kept for a typical week or two each year, there will be evidence to support the deduction.
Similar advice applies to use of the car itself. Although the rules haven’t changed, the IRS’ zeal to enforce them has intensified. Because of all the driving doctors may be doing between offices and hospitals, the agency says business vs. personal car use is crucial in all cases. If the practice is audited, you can pretty much expect this to be scrutinized.
Make sure employees can clearly identify the non-deductible portion of their car use — the first trip from home and the last trip back home each day — so deductible practice-related travel in between can be nailed down.
Entertainment is another area where practice groups can anticipate plenty of attention. Certainly, groups can deduct the cost of entertaining doctors to cultivate referrals or other practice-related benefits, but be prepared for a host of questions. IRS agents will ask specifically what benefit was expected, the number of referrals expected and received, whether the entertainment did in fact increase referrals, and whether doctors in the same specialty and geographic area have similar business/entertainment expenses. What’s more, they’ll be skeptical if the same doctors are repeatedly entertained; that would suggest a personal rather than a business motive.
Federal and state laws prohibit hospitals from paying private practices for referrals. Instead, they may offer all kinds of non-cash incentives to get them to locate nearby or refer patients.
The IRS will look for any of the following, all of which might be considered taxable
compensation:
• Purchase of a practice for more than fair market value.
• Provision of free services (management, financial, marketing, computer, etc.).
• Subsidized office space.
• No- or low-interest loans.
• Forgiven loans.
• Payment of personal expenses.
Each perk would be subject to special rules. For instance, if the IRS decides there has been overpayment for a practice, this isn’t likely to add to the taxable income if you’ve already reported the sale price. But favorable capital gains rates would be denied on the amount considered overpayment.
If anyone within the office — even another doctor — is paid as an independent contractor, watch out. The temptation to treat a worker as an independent contractor is great. The office needn’t pay Social Security or other payroll taxes for such an employee or provide retirement or other fringe benefits. Many workers prefer the arrangement too, because it means fewer restrictions on their business deductions. The IRS would rather have workers classified as employees, though, and the new audit guide will say more about that topic than any other subject.
You should start with the most sensitive issue: doctors’ employment status. You might think it would be hard for the IRS to reclassify a doctor as an employee, since physicians routinely exercise independent judgment — one of the standard criteria for an independent contractor. But since all doctors are supposed to exercise independent judgment, the IRS gives that factor little weight. Instead, the agency focuses on the degree to which a doctor is integrated into the practice, the regularity of his work, the authority he has in the office, and the extent to which he has the same rights and privileges as an employed doctor.
Many doctors and accountants think a critical issue is whether the physician is full- or part-time. That distinction doesn’t impress the IRS, though, unless practices can show how it bears on the specific factors the agency is evaluating.
But the IRS does eye with suspicion doctors working for hospitals, particularly when the physicians are incorporated and the payments are made by one corporation to another. Although the IRS lost in court to an individual who incorporated to avoid being classified as an employee, the audit guidelines make clear that the agency is going to continue to fight. Administrators should get hospital-based physicians to review the independent-contractor criteria, even if their arrangements haven’t been challenged in the past.
Since nurses don’t have the inherent authority that doctors do, different factors determine whether they’re independent contractors. The IRS considers the type and nature of their services, the control they exercise (if any), whether the nurse is licensed, and whether he or she has an independent business. This last factor is crucial. If a nurse works for several doctors or even has some patients of his or her own, you’ve got a strong argument that the nurse is an independent contractor.
What about other workers? In most cases, you should treat them as employees. Only someone running a genuinely separate business whose work is truly ancillary to your practice — for example, your lawyer or your accountant — is likely to be an independent contractor.
If the practice where you work is like most practices, you use cash-basis accounting. That means income is not reported until it is received or deductions are not taken until the expenditures are made.
By contrast, under the accrual accounting method, you’d have to report income when you’ve done everything necessary to earn it and deductions when the liability becomes fixed. Put simply, your accounts receivable would be taxed as though you’ve already received them, your payables deducted as if you’ve already paid them. The IRS prefers this method because it supposedly creates a more accurate picture of net income. But doctors generally avoid accrual accounting because their receivables usually exceed their payables, and they’d rather not accelerate the income.
Practices examined for inventories
Ordinarily, the IRS won’t challenge the decision to report on a cash basis. But if a practice sells medical devices, pharmaceuticals, or any other product that it considers ìinventory, the agency has the authority to change their accounting method to accrual.In most cases, whether or not something is classified as inventory hinges on whether it is sold separately. Patients are not charged for bandages, so the IRS treats them as supplies rather than inventory.
But that rule doesn’t always apply. The IRS states, for example, that prescription drugs constitute inventory whether or not practices charge separately for them. The IRS also cites orthopedic devices in an orthopedic clinic as an example of inventory.
This may seem like a fairly insignificant tax issue, but big bucks ride on the distinction. Ask yourself or your bookkeeper what would happen if your year-end receivables were included in your income, and you’ll get a sense of how key an issue this is.
Make sure the accountant for the practice gets a copy of the audit guide. In fact, you may want to request one yourself. In the meantime, take advantage of the sneak peek we’ve provided. The more you know about what the IRS will look for, the more prepared you’ll be and the better your chances of surviving a tax audit unscathed.
(Editor’s note: The above was reprinted with permission from Medical Economics magazine. Copyright 1997 by Medical Economics Co.)
You have reached your article limit for the month. Subscribe now to access this article plus other member-only content.
- Award-winning Medical Content
- Latest Advances & Development in Medicine
- Unbiased Content