Accrual Basis Taxpayers & Contractual Allowances

August 10, 2006

The taxpayer in question operated separate medical facilities, which had over a million active patient accounts. Its primary source of revenue was remuneration for the provision of medical “services” to patients at the medical facilities. The term “services” includes the provision of medical devices, prescription drugs, and other items that are necessary to provide proper medical treatment to each patient. The taxpayer received payment for its medical services from the government, third-party payors (i.e., managed care payors), and patients.

As a patient is treated in the taxpayer’s medical facilities, the taxpayer recorded standard charges on its books for the medical services provided. These standard charges were determined by the taxpayer and changed over time, typically on an annual basis. The taxpayer was not owed, or entitled to receive, the recorded standard charges except with respect to certain self-pay patient accounts, which happened infrequently. Each medical facility of the taxpayer had managed care contracts with third-party payors who insured the patients. These contracts incorporate one or more insurance plans (“I-Plans”). These contracts were typically negotiated between each medical facility and the third-party payors; in some cases, the contracts were negotiated on behalf of the taxpayer’s medical facilities on a regional basis rather than by each individual medical facility.

These managed care contracts and I-plans established the reimbursement terms that govern the amount a particular medical facility is owed and was entitled to receive for covered medical services. Each managed care contract/I-plan contained distinct reimbursement rates and formulas. For example, certain medical services may be reimbursed on a case rate basis (e.g., a flat rate reimbursement for all cardiac-related services provided during the patient’s stay ), others on a per diem basis, a Diagnostic Related Group (DRG) basis, a cost-plus basis, or a combination of these and other reimbursement methodologies. In addition, other managed care contact/I-plan terms, such as stop-loss provisions (i.e., provisions that change the method of reimbursement if gross charges for a particular service exceed a threshold amount), may determine the reimbursement for services rendered to particular patients.

After providing medical services to patients, the taxpayer’s medical facilities submitted bills to third-party payors and patients. The difference between the standard charges and the amounts that the taxpayer’s medical facilities are owed, and entitled to receive, is referred to as a “contractual allowance.” Standard charges were reported net of contractual allowances (as computed by the taxpayer) in the taxpayer’s revenues and accounts receivable. This contractual allowance did not constitute bad debt because the taxpayer was not entitled to receive the standard charge. The taxpayer’s accounting for bad debt adjustments is included in its computation of uncollectible amounts.

The taxpayer reported “net patient service revenue” as “gross receipts” on line 1 of its tax returns in question. It used computer programs to compute contractual allowances at the time of billing for governmental receivables and a certain percent of managed care revenue. The taxpayer’s medical facilities used these computer programs in determining the expected payment due from a third-party payor for medical services provided to a particular patient by applying the reimbursement terms of the relevant I-plan. This process was referred to as “modeling.” Managed care contractual allowances determined through modeling were reported in the patient accounts receivable at the time of billing.

The Taxpayer’s methodology for computing contractual allowances for accounts that were not modeled (non-modeled accounts) involved the use of estimates, but the facts concerning the taxpayer’s exact methodology in determining and using the estimates was in dispute between the IRS and the Taxpayer. According to the IRS, the taxpayer utilized a general method of accounting for determining contractual allowances for non- modeled accounts as well as various “specific accounting techniques.” Specific accounting techniques ranged from “unsupported opinion to application of historical collection percentages to monthly averaging, and include items other than contractual allowances, such as contingencies and collection issues.”

The IRS agreed conceptually with the manner in which the taxpayer accounted for contractual allowances for patient accounts that were modeled. The IRS disagreed, however, with the taxpayer’s use of estimates to determine contractual allowances for certain non-modeled accounts.


Section 451 of the Code 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.

In this case, the IRS was challenging the taxpayer’s interpretation of the second prong of the all events test but not the first prong. Thus, the IRS and the taxpayer agreed that under the first prong, the fixed right to receive income occurs in the taxable year in which the medical services are performed or goods are provided.

Under the second prong, the IRS and the taxpayer disagreed on what standard is appropriate in determining the amount of contractual allowances, and thus, income with reasonable accuracy. While the IRS and the taxpayer agreed conceptually that contractual allowances may be excluded from total receivables in determining gross income to the extent the rights to such contractual allowances are set forth under the terms of legally enforceable contracts, the IRS and the taxpayer disagreed on whether the amount of the contractual allowance could be determined using estimates or must be determined utilizing the actual contractual in formation available at the end of each taxable year. Specifically, the IRS argued that the taxpayer had on hand by the end of each taxable year all the contractual information necessary to determine the exact amount of a contractual allowance on a contract by contract basis. Thus, the IRS believed the taxpayer must use this contractual information rather than estimates to determine contractual allowances in order to meet the reasonable accuracy standard.

In contrast, the taxpayer argued that the degree of accuracy necessary to constitute reasonable accuracy did not require taxpayer to measure income with precision. Thus, the argument went that even when information is available from which to make a precise determination if there were unlimited time and resources, the courts and the IRS have taken into account the burden, cost and complexity of precision in evaluating the reasonableness If a taxpayer’s approach, and have not always required a precise determination.


As a general rule, accrual basis taxpayers may use estimates to determine the amount of contractual allowances to be excluded in determining gross income to the extent the use of estimates results in gross income determined with reasonable

Although this case involves the accrual of income under §451, the all-events test for determining the accrual of deductions under §461 also required that the amount of the liability be determined with reasonable accuracy. The IRS acknowledged that the last event necessary to establish the fact of liability under the all-events test is the same event that fixes the right to receive income under the all-events test. Accordingly, interpretations of the reasonable accuracy prong of the all-events test are applicable in analyzing the reasonable accuracy prong of the all-events test accuracy. In this case, the use of estimates may be appropriate according to the IRS. Whether the taxpayer’s particular methods of estimating the amount of contractual allowances meets the reasonable accuracy standard is a question of fact to be determined by the IRS. In order to use estimates, the taxpayer must show that its methods of estimating are reasonable and properly reflect actual experience. If the Taxpayer fails to do this, the IRS may deny a taxpayer’s methods of estimating the amount of contractual allowances unless the taxpayer adopts a more reasonable method of estimating that is based on actual experience.

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