Tax Court Decides Cash Basis of Accounting Case – Potential Positive Impact for Veterinarians
By Edward K. Zollars, CPA
In the past there has been much discussion of the potential for the IRS to require veterinarians to report their income on the accrual basis. Much of this discussion has centered around the issue of whether veterinarians are in the business of selling "merchandise" which would require inventories and the use of the accrual basis of accounting. If that occurred, a practice would be required to expense medical and other supplies as they were used or sold, and would have to pick up in income any open accounts at the end of a year, rather than waiting for cash to be collected.
There are two broad areas that it has been suggested the IRS might use to assert that veterinary practices are in the business of selling merchandise. First, it is suggested that the medical supplies used in the practice would constitute merchandise, so that drugs held to be administered and other supplies used in veterinary medical treatment would be "tainted" goods that would bring down accrual accounting. In fact, in an IRS Field Service Advice that was written in 1993, but just released as a public document this year (FSA 1999-939), the IRS asserted that this alone was enough to require the accrual basis of accounting. Second, the IRS has also shown an interest in the sale of pet foods and accessories that are not administered by professional staff, but rather are sold to the general public.
The Tax Court on November 22 came down with a case involving an oncology clinic that helps veterinary practices on the first issue (that of the use of medical supplies) but whose logic may hurt clinics on the second issue (the sale of other items directly to the public). In the case at hand (Osteopathic Medical Oncology and Hematology, P.C.), the court was dealing with an oncology practice that kept an approximately two week supply of chemotherapy drugs on hand at all times
The IRS had attempted to use the fact that these drugs were used in the practice to force the clinic to partially adopt the accrual method of accounting. That is, the IRS was asking the court to force the practice to a) keep an inventory of the chemotherapy drugs and only deduct them when they were actually used and b) to force the clinic to record accounts receivable related to the drugs used as income when they were billed.
The regulations generally hold that the IRS can force a business on the accrual basis if the IRS can carry two issues. First, that the taxpayer sells merchandise in the operation of the business. And, second, that the sale of such merchandise is a material income producing factor.
The full Tax Court, in a split decision, held against the IRS in this case. A significant majority of the court held that the chemotherapy drugs were not merchandise due to a number of factors. First, the clinic was prohibited from selling the drugs except as part of a treatment regimen that the clinic administered. Second, the use of the drugs was seen by the court as an inseparable part of the provision of medical services in these cases. In differentiating this case from one involving a funeral parlor (which sold caskets as part of the overall funeral services) the court noted that patients generally did not participate in the selection of the particular drugs involved and the drugs were not put on display for patients as part of a sales process.
It is important to note that the Tax Court felt this was an important decision that should be binding in future Tax Court decisions. Most decisions of the Tax Court are published in "memorandum" format, which means that, in the judgement of the court, the case in question decides a well settled area of law. However, when the Tax Court feels that a case does break new ground and decides an issue in a way that should be binding on the Tax Court judges in the future, the court issues what is called a "published" decision. This case was handled as a published decision.
Applicability to a Veterinary Practice
As I noted above, this case is both good news and bad news. From the good news perspective, the case makes clear that drugs/supplies administered by your professional personnel and/or consumed in the process of providing care clearly are not merchandise. Drugs that are dispensed to the client to be administered to the animal at home are not so clearly excludable in this case, though I think a good argument can be made that this continues to be part of the service. Additionally, their sale is still subject to sufficient restrictions to allow use of part of the logic of this case. At the very least, the logic of the 1993 IRS Field Service Advice is directly contradicted on a number of points by this opinion, at least in terms of the importance attached to the difference between veterinarians and "human-based" doctors. In the oncology case decided by the Tax Court, we had the direct administration of drugs as part of the medical practice and a court ruling that such drugs were not merchandise, despite IRS arguments that repeated those in the veterinary field service advice.
Consumer type supplies (pet foods, accessories and the like) would seem to clearly fall within the definition of "merchandise" that the Tax Court laid out in this case. So it would appear that the sale of such items does pose some risk that, at a minimum, a clinic might be forced to use a "hybrid" method of accounting (that is, reporting on the accrual basis for sale of such merchandise). In the IRS Audit Technique Guide for Veterinary Medicine, the IRS implies that only if the clinic’s records segregate sales and expenses related to merchandise sufficiently should an agent allow the use of the hybrid method—otherwise the clinic should be forced to use the accrual basis for all sales.
Since we likely have merchandise, even under this case, the issue will be whether such merchandise is a material income producing factor. In the above referenced Audit Technique Guide, the IRS states that "courts have found that merchandise is an income producing factor in a taxpayer's business where its cost is approximately 15 percent of the taxpayer's cash method gross receipts." We can interpret that to mean that the IRS is effectively applying a 15% test for gross receipts.
From a practical standpoint, for most small veterinary clinics, this will not prove to be a problem so long as the drugs are excluded from the computation (and Osteopathic Medical Oncology and Hematology, P.C. case certainly suggests they can be). The real issue becomes the potential impact of drugs held not to be administered on site, but to be sent home with the animal’s owner to be administered.
The arguments in support of excluding those drugs from the base includes the fact that such drugs are only available for sale as part of the provision of medical services. That is, you aren’t running a pharmacy open to the public issuing drugs to any and all comers who bring in a prescription. Additionally, to quote the IRS’s own guide on this point, you stock drugs because "most practices act as a pharmacy since commercial pharmacies rarely have the required type or amount of pharmaceuticals for animals." Your veterinary medical services could not be properly carried out without those drugs on the premises.
That doesn’t mean the IRS won’t try and argue that those drugs are merchandise. But I think there is a good chance of getting those drugs excluded from the equation and that the Osteopathic case helps in that regard.
There is some danger, as pointed out in one of the concurring opinions, that the IRS might be able to make a case that while you can’t be forced to the accrual method, you could be forced to capitalize the drugs as a prepaid expense item only deductible in a later year as the items are consumed. In this case, the drugs are seen as a supply rather than as an item of merchandise. The fact that so many of the judges felt compelled to write in this case (there is the main opinion, two concurring opinions and one dissenting opinion) indicates that this area is still a confusing one even for the Tax Court judges. But until the IRS actually argues for a need to capitalize those expenses, I’m would not be terribly concerned about the issue unless an inordinate amount of drugs were actually stored on site.
Conclusions
In general, I believe this case is good news for most veterinary practices. Absent an IRS appeal of the case that would overturn the result, it denies the IRS the ability to claim that the use of drugs and supplies while performing medical services constitutes the sale of merchandise.
Had the Tax Court decided this case with the opposite holding (that the sale of drugs did constitute merchandise in the oncology practice), it would have put a number of practices at risk for, at a minimum, a partial use of the accrual basis. Remember that the audit guide suggests that IRS auditors look for expenses in excess of 15% of the total revenue that might be considered merchandise—and for a number of practices, such a number would come very close to or be less than the amounts spend in total on drugs, diets and supplies.
The only action a clinic might take with regard to this case would be to assure that drugs are segregated from items that clearly are merchandise in your accounting records. That is, you should not have a single account for "drugs, diets and supplies" but rather should break out drugs and medical supplies into a separate category apart from pet foods, leashes, etc. that you may purchase both for sale to customers and for use in the clinic.
Developments will still need to be monitored to see how the IRS fares in other cases involving the cash basis. The 15% test the IRS bandies about in the veterinary practice guide came from a case the IRS won against a newspaper publisher where the court that the 15% figure represented a level that was "material" to income production. Should the IRS win a case with a lower cost level, we may find the sale of pet supplies becoming an issue again. Similarly, the IRS may decide to adopt the position suggested of treating such drugs as supplies, a position that might find a more sympathetic ear on the Tax Court.
But, for now, most veterinarians face a reduced risk of having the IRS attempt to switch their practice to the accrual basis.
Author: Edward K. Zollars, C.P.A. is a shareholder in the Phoenix CPA firm of Henricks, Martin, Thomas & Zollars, Ltd. He has served on committees and task forces on the national and local level for the American Institute of CPAs and the Arizona Society of CPAs, as well as having lectured at continuing education presentations for the American Institute of CPAs, Arizona Society of CPAs, Florida Institute of CPAs, Virginia Society of CPAs and Virginia Tech University. Most recently he lectured at the AICPA’s National Conference on Federal Taxes and the Virginia Accounting & Auditing Conference (jointly sponsored by the Virginia Society of CPAs and Virginia Tech University).
Ed has written articles that have been published in the Journal of Accountancy and The Tax Adviser. He also is a regular contributor to the Internet newsgroup misc.taxes.moderated.
More information can be found by looking at the following documents:
IRS MSSP Audit Guide for Veterinary Practice (PDF file, requires Adobe Acrobat Reader) from the IRS Web Site
Tax Court opinion in Osteopathic Medical Oncology and Hematology, P.C. (PDF file, requires Adobe Acrobat Reader) from the United States Tax Court site.