IRS Finally Weighs in on IBNR Deductibility

July 26, 2015

In a recent Field Service Advice memorandum, the Internal Revenue Service concluded that a company providing health care service was not an insurance company as defined by the Internal Revenue Code, but more importantly, it could however accrue and deduct IBNR (Incurred but not Reported). This is an extremely important development for independent practice associations, group practices, and any healthcare company with risk bearing contracts. Up to this point, there has not been a specific cite within current IRS rules and regulations stating that a risk bearing IPA or other healthcare entity can deduct its IBNR reserve. The only position where this issue has been addressed is the well-known and cited General Dynamics Supreme Court tax case.

General Dynamics

The Supreme Court in this case held that an accrual basis taxpayer that maintained a self insured plan for employee medical expenses was not entitled to a deduction for an estimated reserve for reimbursement of employee medical expenses incurred by employees but not reported to the taxpayer (U.S. v. General Dynamics Corp.,107 S Ct 1732 (1987)). The Court noted that only insurance companies, by specific statutory provision, are allowed a deduction for reserves for claims that have been incurred but not reported (IRC 832(b)(5)).

The court stated that it is fundamental to the ‘all events test’ that, although expenses may be deductible before they have become due and payable, the liability must first be firmly established. This statement is consistent with the court’s prior holdings that a taxpayer may not deduct a liability that is contingent, nor may a taxpayer deduct an estimate of an anticipated expense, no matter how statistically certain, if it is based on events that have not occurred by the close of the taxable year.

In this specific situation, the missing event in order to fix liability was the filing of properly documented claims forms by the medical providers. The Court pointed out that as a matter of law, the filing of a claim was necessary to create liability. According to the ruling, “Such filing is not a mere technicality. It is crucial to the establishment of liability on the part of the taxpayer.” The Court also stated in the General Dynamics case that with regard to the use of actuarial data to estimate the IBNR deduction, that even though the taxpayer may have been able to estimate how many claims would be filed for the period at issue, this fact alone did not justify a deduction.

Finally, the Court stated that “a reserve based on the proposition that a particular set of events is likely to occur in the future may be an appropriate conservative accounting measure, but does not warrant a tax deduction.” This is the fundamental problem with risk bearing IPAs and other healthcare entities since they must estimate an amount of claims that will be filed after the close of the accounting period for services rendered to patients before the close of the period. If not, the IPA or healthcare entity may think the excess funds in the bank account is profit and could distribute them out as compensatory bonus and/or dividend payments. If this occurs, the result is that too few funds are available in the future to pay for claims that will be submitted by providers. This is why IPAs and healthcare entities that must and do reserve IBNR liabilities want to make sure these reserves are tax deductible.

IRS Field Service Advice

IRS agents conducted an examination of a company that is a professional corporation owned by physicians and an HMO. The company receives 80 percent of its income from capitation payments under a contract with the HMO for providing service to the HMO’s members. The company deducted its yet-unreceived claims (IBNR), but the IRS agents argued that the company could not deduct the IBNR reserve because the all events test had not been met. The agents then requested advice from the National Office of the Internal Revenue Service regarding this matter.

The company used the accrual method of accounting for both book and tax purposes. Capitation payments from the HMO were recorded in income in the month for which coverage is provided. Revenue from fee-for-services patients is recorded in the period in which the services are performed.

The company often referred patients to outside specialists, also known as referral physicians. Under its contract with the HMO, the company was required to pay for the services provided by the outside specialists. If a claim submitted by an outside specialist is approved by the HMO, it became the company’s liability, subject to a risk/reward clause under which the HMO and the company shared in the referral expense variance. The charges for outside medical services provided to the company’s members were recorded by the company in the period in which the services are provided. These charges include amounts based on estimates for reported charges as well as estimates for services performed by outside specialists but not reported (IBNR) by the outside specialists to the HMO. The IBNR amount was based on a per member per month actuarially estimated amount. It was not based on the number of referrals outstanding at year-end. The company did not know the cost for an outside specialist until a claim is filed because the cost could vary depending on how many times the patient visited the specialist, and whether the specialist ordered additional treatment.

As previously mentioned, the IRS field agents’ position was that the company could not deduct an IBNR reserve because the all events test has not been met, and based the General Dynamics case, the medical liability required a claim form for payment. The agents in the field also believed that the company sought to deduct an actuarial estimate of the claims it expects would be filed in the future, and that the last event creating the liability occurs when a specialist actually submits a claim for payment.

The National Office of the IRS stated in the Field Service Advice memorandum that this situation was distinguishable from General Dynamics. Specialists provided specific preauthorized medical services with the understanding that they will be reimbursed by the company. There was no reason for the specialists not to seek payment for their services. In this context, the submission of a claim merely verified that medical services had been provided, and it is the provision of services that establishes the fact of the company’s liability. Thus, the filing of the claim by a specialist is a ministerial act, not a condition precedent that is necessary to establish the company’s liability.

The Field Service Advice goes on to mention that Section 461(h)(2)(A) provides that if the liability of the taxpayer arises out of the providing of services or property to the taxpayer by another person, economic performance occurs as such person provides such services or property. Treasury Regulation section 1.461-4(d)(6)(i) provides that services or property provided to a taxpayer includes services or property provided to another person at the direction of the taxpayer. In this case, the company referred patients to outside specialists, and under its contract with the HMO was required to pay for the services provided to patients by the specialists. Thus, the company’s liability arises out of the providing of medical services and economic performance occurs as the specialists provide medical services. At the time the medical services are provided, the fact of the liability has been established and economic performance has occurred with respect to the liability. [Emphasis Added].

Where a claim for payment, in which processing is ministerial, is required from a business in a commercial transaction, the fixing of the liability is not delayed until the claim is filed according the IRS. The claim filing itself is ministerial in that it is not essential to the process of fixing the liability. This is in contrast to the General Dynamics case where the claim was essential for the employee to receive reimbursement. Once medical services have been preauthorized and services are provided, an accrual is appropriate if it can be verified that the company had made a reasonably accurate estimate of its liability. Therefore the IBNR accrual is deductible by the taxpayer.


It is important to note that the Field Service Advice mentions that in the General Dynamics case, the court noted that 82.2% of the accrued reserve amount sought to be deducted was subsequently paid, and this percentage was well within the reasonably accurate range accepted by the courts for the purposes of satisfying the second prong of the all events test. Therefore, it is important that the IBNR accrual be compared each year to the actual amount of claims that were paid for services rendered in the tax year of the IBNR accrual. If the two amounts are materially different, an amended tax return would most likely have to be filed reflecting a reasonable deduction for IBNR.

Finally, it is important to note that Field Service Advice from the Internal Revenue Service is not binding and cannot be used to cite as a precedent. However, this is the first good news from the Internal Revenue Service that non-insurance companies can accrue and deduct IBNR.

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