Taxpayer's Right to Income Neither Fixed nor Capable of Reasonable Estimate at Year End, So Not Included in Income Until Received

All too often we, as tax practitioners, are tempted to say that a matter is “just timing” when looking at whether something has been properly handled on a tax return.  That is, it was properly included in income or properly deducted, just perhaps in the wrong year. 

But, as we all know when we think about the issue, “just timing” is actually a very important issue to our clients and the IRS, as well in the financial reporting arena when preparing financial statements.  But tax rules and FASB’s provisions don’t look at the matter in the same way.

Right now, of course, the Financial Accounting Standards Board is in the process of moving to a new revenue recognition standard, but conceptually the goal for financial reporting is the same as it’s been in the past—to attempt to reasonably match revenue with expenses using the best available information at the time a statement is prepared.  That can include information obtained after the end of the year in question, so long as its available when the financial statement is being prepared.

Taxes don’t work that way, and in Chief Counsel Advice 201607026 the IRS looks at applying the tax rules to a situation involving Medicare incentive payments to certain providers under provision of the Affordable Care Act.

The tax rules for income recognition for a taxpayer on the accrual basis of accounting is summarized as follows in the memorandum:

Section 451 of the Internal Revenue Code provides the general rule that the amount of any gross income shall be included in gross income for the taxable year in which received by the taxpayer, unless such amount is to be properly accounted for in a different period. Accrual method taxpayers recognize income "when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy." Section 1.446-1(c)(ii) of the Treasury Regulations.

So, effectively, an accrual basis taxpayer is going to recognize income using the following test:

The program in question gave an incentive a qualifying electing organization (referred to as “affordable care organizations” or ACOs) receiving fee for service (FFS) payments under Medicare to receive payments for “shared savings” for a group of patients if the organization meets certain quality performance standards.

As the memorandum describes the program:

Section 1899(d)(2) of the SSA (Social Security Act) provides that, if the ACO meets the quality performance standards established by the Secretary, “a percent (as determined appropriate by the Secretary) of the difference between such estimated average per capita Medicare expenditures in a year, adjusted for beneficiary characteristics, under the ACO and such benchmark for the ACO may be paid to the ACO as shared savings and the remainder of such difference shall be retained by the program under this title.” This percentage is referred to as the “savings rate.” This section also requires the Secretary to establish limits on the total amount of shared savings that may be paid to an ACO. This limit is referred to as the “sharing cap.”

The taxpayer in question had organizations that were participating in this program for the years in question.  However the taxpayer argued that, due to a number of uncertainties related to the program, the amount it had earned for a year was not properly reportable in that year but rather in a later year when it actually received payment under the program. 

Examination did not initially agree with this view and asked the Chief Counsel’s office for guidance.  Based on the facts of this situation, the Chief Counsel’s office sided with the taxpayer.

The income in question failed to meet the first criteria (the “all events test”) because the taxpayer did not have a fixed right to receive the income as of the end of the tax year.  The memo points out:

For instance, the beneficiaries used to determine an ACO's performance are assigned retroactively, after a three month claims run-out. The MSR (minimum savings rate) is dependent on the number of assigned beneficiaries and, during the tax years at issue, knowable only after the final number of assigned beneficiaries is determined. The benchmark of expected average per capita FSS (sic) expenditures is determined approximately six months after the performance year ends. The beneficiary per capita costs for the performance year are determined retrospectively, after the three month claims run-out, and can include FFS claims billed by other practitioners if the FFS beneficiaries received care outside the care rendered to them by the ACO practitioners. At the conclusion of their tax year, the ACO practitioners may not have knowledge of all of the other FFS claims.

As well, the National Office concludes that, as of the end of the year, the amount cannot be determined with reasonable accuracy.  This determination is made as of the end of the tax year.  While the amount doesn’t have to be absolutely certain to be the amount received (any difference is taken into account in the year received if there is a difference), there must be a reasonable basis for the estimate. 

In this case the memorandum concludes there is no such reasonable basis given the facts.  As the analysis continues:

In the instant case, the facts from which a calculation could be made were not knowable at the end of the tax year. At the end of the tax year, the Taxpayer did not know the beneficiaries used to determine its performance as those beneficiaries were not assigned until after a three month claims run-out after the close of the performance year. The MSR is dependent on the number of assigned beneficiaries and knowable only after the final number of assigned beneficiaries is determined. The performance benchmark is determined approximately six months after the performance year ends. The beneficiary per capita costs are determined after the three month claims run-out. The Taxpayer is given the sample of beneficiaries for whom it must report quality performance on certain measures after the close of the performance year and this quality performance impacts the final savings rate.

Of course most taxpayers are not organizations participating in this particular program.  But the analysis of the law the memorandum goes through applies in any case where the question arises regarding the proper year in which an item is to be recognized for income tax purposes.