When preparing a tax return for an Independent Practice Association (IPA) the largest expense is generally purchased medical services. A significant amount of the purchased medical services expense is the Incurred But Not Reported (IBNR) liability. There are two methods used to deduct purchased medical services associated with IBNR.
If the IPA accepts full risk capitated contracts to provide health care services to a significant number of health plan enrollees, IBNR can be estimated and deducted by filing under Internal Revenue Code Section (IRC) 832 as an Insurance Company. The essence of this is if an IPA has the characteristics of an insurance company, the IRC allows estimated IBNR as a deduction.
The second method IPA’s can use to calculate and deduct IBNR is the “Recurring Item Exception” found in IRC 461(h)(3). This states that an item is treated as being incurred during the year if (1) the “all events test” is met during the year; (2) “economic performance” occurs within the shorter of a reasonable period of time after the close of the year end, or within eight and one half months after the close of the year; (3) the item is recurring in nature; (4) the taxpayer treats all similar items consistently and (5) the amount is immaterial or the accrual of the item results in a more proper matching of expense with revenue.
Let’s examine the significant recurring item exception requirements and compare them to IBNR. First, does IBNR meet the “All Events Test” standard? The all events test standard says that a liability can be deducted when all the events have occurred which determine the fact of the liability and, the amount can be determined with reasonable accuracy. For IBNR, what determines the fact and amount of the liability? According to U.S. vs. General Dynamics Corp., (1987, S Ct.) a medically self-insured corporation could not deduct a reserve for claims submitted, but not processed (IBNR). In this case the Court held that the all events test was not met because the final liability was not owed until the claim was received. Since the corporation could not prove what claims were received but not paid, the Court disallowed the IBNR reserve deduction.
So, after General Dynamics, is there a way for IBNR to satisfy the all events test? In today’s IPAs, IBNR liability is generally calculated monthly and involves analysis of a claims lag report. It is an estimate, based on historical assumptions, that claims submission patterns will be similar month to month and year to year. If an IPA bases its IBNR reserve deduction on extrapolating a claims lag analysis, there probably is an issue similar to that of General Dynamics; there is no proof that the claims were received and the all events test would not be met. If however, the IPA bases it’s IBNR deduction on actual claims filed and paid subsequent to the year end, the all events test should be met.
How about IBNR and the economic performance test? The definition of economic performance is that it occurs as services are provided. When management calculates IBNR, has “economic performance” occurred? I would answer, yes, because one of the basic assumptions that must be made when calculating IBNR, is that medical services have been provided. So IBNR should pass the economic performance test portion of the recurring item exception.
Let’s briefly touch the third and fourth requirement in IRC 461(h)(3) that require items to be recurring in nature and have like items be consistently treated. What is the essence of IBNR? It is an estimate of a liability that is comprised of medical provider claims for services rendered. Are these claims recurring in nature? I believe the IRS would take that position as the IPA pays claims for the same and similar medical services month in and month out. What about consistent accounting and tax treatment of the claims? They should all be charged to a medical expense account of some kind. The IRS should concur that they are consistently treated claims.
The fifth and final requirement of the recurring item exception is the amount of the liability must either be immaterial or the accrual of the item would result in better matching of expense with revenue. IBNR is generally not immaterial and would not qualify under the first half of the requirement. What about matching of expense with revenue? If one looks at IBNR, what is management trying to do? They are matching medical services provided with capitation revenue received. Additionally, IRC 461(h)(3)(B) says that when determining whether the item should be accrued under the matching principle financial statement treatment shall be taken into account. As a result, if the IPA’s financial statements treat IBNR as an expense it should be allowed as an expense under the recurring item exception.
In summary, if an IBNR calculation is an estimate, it should only be deducted by IPAs filing under IRC Section 832 as insurance companies. However, using the recurring item exception under IRC Section 461(h)(3), IPA’s should be able to deduct amounts for services provided during the fiscal year which are paid within eight and one half months of the year end. In effect, deducting IBNR on an actual basis. To use the recurring item exception there should be sufficient documentation to support the claimed deduction. The minimum documentation I recommend is a claims lag report that is run as close as possible to the extended filing date of the IPA’s tax return. Additionally, the IPA must use the accrual method of accounting.