IRS Audit Readiness Checklist for Healthcare Organizations

In May, President Biden and the Department of the Treasury released their fiscal year 2022 revenue proposals. A major increase in funding for the Internal Revenue Service (IRS) is expected as Biden has proposed spending nearly $80 billion over the next 10 years to help the IRS pursue audits and make operational improvements. The increased funding is intended to stimulate a renewed focus on generating revenues from income tax audits.

Income tax audits are time consuming, disruptive and costly. Healthcare organizations should be proactive in ensuring that they have properly vetted and documented the technical basis for their tax positions. We’ve created the checklist below, showing main areas to consider, to help you start assessing your readiness.

Filing Methodologies Under Friendly Physician Arrangements

Private Letter Ruling 201451009 established that a taxpayer utilizing a “friendly physician” model, containing a management service organization (MSO) and an associated professional corporation, could file a consolidated tax return under §1504(a).

• Ensure that you have the proper elections in place to file consolidated returns, are maintaining accurate separate legal entity financial statements and are filing the consolidated tax returns appropriately.

Management Service Agreements (MSAs) and Related Party Transactions at Fair Value and Arm’s Length

Section 482 requires the MSA and related party transactions to be structured in a manner that meets the definition of an arm’s length transaction. The IRS wants to ensure that the profits being transferred to the MSO meet this criteria!

• Maintain and update benchmarking studies and valuations to support similar fee structures utilized across the industry in similar circumstances.

Methods of Claiming Deductions for Bad Debts

In order to deduct a bad debt under §166, you must establish the following criteria:

• The existence of a bona fide debt as described in §166, i.e., indebtedness that arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money (including accounts receivable).
• If the debt represents an item of income (e.g., fees, rents, or similar items), it has been (or is being) taken into income.
• The debt became worthless in the tax year in which the deduction was taken.

This could be an administrative nightmare to accumulate all documentation regarding worthlessness and could lead to unintended audit risk if receivables are not properly written off using the aforementioned criteria. Fortunately, §1.448-3(a) provides for the non-accrual experience method and allows a taxpayer to exclude income that “on the basis of the taxpayer’s experience, and to the extent determined under the computation or formula used by the taxpayer and allowed under this section, will not be collected.”

• Ensure that you are using the most advantageous method (specific charge-off or non-accrual experience) from a risk, administrative ease and tax benefit standpoint.

Fixed and Determinable Bonus/Incentive Liabilities

Under IRC §461, an accrual basis taxpayer can deduct an accrued liability in the year of accrual if the following conditions are met:

• All events have occurred to establish the fact of the liability.
• The amount of the liability can be determined with reasonable accuracy.
• Economic performance has occurred with respect to the liability.

Revenue Ruling 2011-29 established that a taxpayer who computes a bonus accrual either through a formula that is fixed prior to year-end or through other corporate action (such as a resolution of the taxpayer’s board of directors or compensation committee made before year-end) has only partially fixed its bonus liability if an employment condition ultimately determines the payout of the bonus.

• Revisit your bonus plan policies to ensure that any bonuses forfeited by terminated employees are reallocated to the remaining bonus plan participants. If the forfeited bonus money reverts to the organization, the bonus liability is considered contingent on an employment condition and is not deductible until the year paid.

Fixed and Determinable Litigation Liabilities

Under IRC §461, an accrual basis taxpayer can deduct an accrued liability in the year of accrual if the following conditions are met:

• All events have occurred to establish the fact of the liability.
• The amount of the liability can be determined with reasonable accuracy.
• Economic performance has occurred with respect to the liability.

Regulation §1.461-4(g)(2) further indicates that economic performance for liabilities arising under a worker’s compensation act or out of any tort, breach of contract or violation of law, occurs as payment is made. This includes alleged instances of these, as well.

• Ensure that you’ve identified all liabilities arising under a worker’s compensation act or out of any tort, breach of contract or violation of law and have deducted them in the year paid for tax.

Fixed and Determinable Contractual Allowances

Pursuant to Technical Advice Memorandum 200619020, an accrual basis taxpayer generally may exclude “contractual allowances” from total receivables in determining gross income if there exists, at the time a service is performed or a good is provided, a legally enforceable contract that provides that the payor incurs a liability for any particular service/good in an amount that is less than the standard billed charge for the same service/good.

• Ensure that you have current legally enforceable contracts with third-party payers to support your reduction in revenue recognized for tax.
• You should also make sure you are recording your contractual allowances consistent with the legally enforceable contracts, rather than as estimates based on historical experience. Liabilities solely based on historical experience could be considered as not being determined with reasonably accuracy.

Deductibility of Incurred but Not Reported (IBNR) Liabilities

Under IRC §461, an accrual basis taxpayer can deduct an accrued liability in the year of accrual if the following conditions are met:

• All events have occurred to establish the fact of the liability.
• The amount of the liability can be determined with reasonable accuracy.
• Economic performance has occurred with respect to the liability.

Field Service Advice Memo (200104011) determined that the liability is actually established and economic performance is met when the services are performed (rather than when the performed services are reported).

• The IMPORTANT conclusion that could be drawn from the FSA is that once medical services have been authorized and services are provided, an accrual is appropriate if it can be verified that the company made a reasonably accurate estimate of its liability.
• Make sure that you are recording a liability for services that have been provided for which claims have not been submitted. Accruals based on historical experience of claims not submitted by year-end could be considered as liabilities for which all events have not occurred to establish the fact of the liability.
• Ensure you are performing a look-back analysis to determine the accuracy of your IBNR accrual. The IRS will ask for this if your IBNR accrual is challenged! If 80% or more of accrued IBNR was subsequently paid, your accrual will generally be considered as determined with reasonable accuracy.

Employee Classification

You must issue W-2s to employees and regularly withhold/remit payroll taxes to the IRS. On the other hand, you do not need to withhold payroll taxes for contractors and will need to issue 1099s for services provided.

• Make sure you are properly classifying employees and contractors using the IRS’ 20-point criteria test. Any employees misclassified would have delinquent payroll tax withholding along with associated interest and penalty. This could be substantial!

By proactively reviewing these areas now, you’ll be better prepared if the IRS comes knocking.