Rev. Rul. 81-176

ISSUE

What is the proper taxable year for an accrual-method taxpayer to report adjustments with respect to income earned for services rendered during the taxable year to Medicaid patients, under the circumstances described below?

FACTS

Taxpayer, whose taxable year is a calendar year and who uses an accrual method of accounting, is engaged in the business of conducting a nursing home that participates as an intermediate care facility under the Medicaid Program as set forth in Title XIX of the Social Security Act. The Medicaid Program is administered by the states through their respective departments of health (the "department"). With respect to taxpayer's patients who qualify for financial assistance under the Medicaid Program, taxpayer annually (on a calendar-year basis) enters a contractual arrangement (the "contract") with the department. This contract entitles taxpayer to compensation for its services rendered to qualified Medicaid patients on the basis of "reasonable cost." "Reasonable cost" is defined under the Medicaid Program as the actual costs incurred by the taxpayer in rendering the intermediate care services to the Medicaid patients plus a 10 percent return on equity capital as a profit factor.

Taxpayer's total compensation under the contract for a year cannot finally be determined until the end of that year (the "contract year"). However, as of the beginning of the contract year, the contract establishes an interim (tentative) rate per Medicaid patient day as a means of currently reimbursing taxpayer for services rendered to its Medicaid patients. This interim rate is based upon the projected "reasonable cost" of providing patient care during the upcoming year. Based on this interim rate, the taxpayer, at the end of each month, bills and receives monthly payments from the department for the care services rendered during such month. While the taxpayer receives such funds unrestricted as to use, the taxpayer is subject to an obligation to repay to the department all amounts billed and received during the contract year in excess of the actual "reasonable cost" incurred during the year to provide patient care as reflected in the taxpayer's "cost report" to be filed with the department.

Taxpayer is required by the contract to submit a cost report to the department within 90 days after a contract year ends. This cost report reflects taxpayer's actual costs incurred during its contract year in rendering care services to Medicaid patients. The cost report must include a certification signed by an officer of the taxpayer. Upon receipt by the department, the cost report is subjected to a desk audit. Revisions are made when necessary, and remittance of the balance due the taxpayer, if any, is made upon settlement of the desk audit. Any refund due the department, as reflected in the cost report, must be paid by the taxpayer when the cost report is filed.

For federal income tax purposes, taxpayer accrues as income the amounts due from the department, based on the interim rates established for services rendered and billed through the end of the taxable year. In cases in which the total monthly billings to the department during the taxable year exceed the actual amount due ("overbillings"), taxpayer, at year end, makes an adjustment to decrease gross income by an estimate, based on prior experience, of the amount that will have to be refunded to the department when it completes, certifies, and files its cost report. While the taxpayer at the end of its taxable year has all the information necessary to readily calculate the exact amount of its compensation under the contract and, consequently, the exact amount of any refund due the department, for administrative ease it consistently uses an estimate as a basis for accrual of its liability to make a refund.

In cases in which the actual amount due for the taxable year exceeds the total monthly billings to the department ("underbillings"), the additional amount due from the department is included in income by the taxpayer in the taxable year in which it is received.

LAW AND ANALYSIS

Section 451 of the Internal Revenue 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 when all the events have occurred that fix the right to receive such income and the amount thereof can be determined with reasonable accuracy. 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.

Section 461(a) of the Code provides that the amount of any deduction or credit shall be taken for the taxable year that is the proper taxable year under the method of accounting used in computing taxable income.

Section 1.461-1(a)(2) of the regulations provides that under an accrual method of accounting an expense is deductible for the taxable year in which all the events have occurred that determine the fact of the liability and the amount thereof can be determined with reasonable accuracy. When a deduction is properly accrued on the basis of a computation made with reasonable accuracy and the exact amount is subsequently determined in a later taxable year, the difference, if any, between such amounts shall be taken into account for the later taxable year in which such determination is made.

Rev. Rul. 66-347, 1966-2 C.B. 196, provides that membership fees received by a taxpayer are includible in income for the taxable year in which received or accrued, depending upon the taxpayer's method of accounting, even though subsequently it may be required to refund part of a fee for each member who leaves the locality of the club during the first 5 years of membership; however, when a refund is made, an accrual-basis taxpayer is entitled to a deduction for the amount of its payment for the taxable year in which the liability to repay accrues.

The "all-events test" of sections 1.451-1(a) and 1.461-1(a)(2) of the regulations contains two different requirements, both of which must be fulfilled prior to the accruing of an item of income or expense. First, to be included in gross income in a taxable year the right to an item of income must be fixed in that year; to be deducted in a taxable year, the fact of the liability must be determined in that year. Second, for purposes of both income inclusion and expense deduction the amount of the item of income or deduction must be determined with reasonable accuracy.

In the instant situation, taxpayer accrues as income the amounts due from the department, based on the interim rates established, for services rendered and billed through the end of the taxable year. In cases in which the taxpayer determines at the end of its taxable year that it has overbilled the department, a deduction is taken from gross income based only on taxpayer's estimate of the probable amount that will have to be refunded to the department. Such an estimate is no more than an assumption, based on prior experience, that costs incurred in providing certain services during the taxable year have remained the same as related costs incurred in prior years. Therefore, taxpayer's practice of deducting estimated refunds in the instant case does not constitute a proper basis for accrual under the all events test set forth in section 1.461-1(a)(2) of the regulations.

In cases in which the taxpayer determines at the end of its taxable year that it has underbilled the department, the additional amount due from the department is included in income by the taxpayer in the taxable year in which it is received. All the events that fix the right to receive income under an accrual method of accounting occur when (1) the required performance occurs, (2) payment therefor is due, or (3) payment therefor is made, whichever happens first. See Rev. Rul. 74-607, 1974-2 C.B. 149. In the instant case, the required performance occurs during the taxable year and taxpayer's right to receive income for such services accrues during the taxable year, to the extent such amount can be determined with reasonable accuracy as of the last day of the taxable year. Therefore, taxpayer's practice of including the amount of its underbillings in income in the taxable year in which payment therefor is received does not constitute a proper basis for accrual under the all events test set forth in section 1.451-1 of the regulations to the extent such amount can be determined with reasonable accuracy as of the end of the taxable year in which the related services are performed.

All of the facts necessary for the calculation of taxpayer's actual "reasonable cost" are fixed as of the close of business on the last day of taxpayer's taxable year, as subsequently reflected in the certified cost report. The exact amount of any refund due the department or any additional payment due the taxpayer, whichever the case may be, may be determined with reasonable accuracy at the end of taxpayer's taxable year. This is the case since taxpayer at the end of its taxable year has all the information necessary to readily calculate the exact amount of its compensation under the contract, and consequently the exact amount of any refund due the department or any additional payment due it. Taxpayer has records that indicate both its actual costs incurred during the taxable year and the interim payments accrued during the same period. Moreover, its balance sheet indicates equity capital both at the beginning of its taxable year and at the end of its taxable year. The excess of the amount of interim payments accrued during the taxable year over the actual costs incurred plus a 10 percent return on average equity capital during the taxable year is the amount that must be refunded to the department. To the extent the interim payments accrued during the taxable year are less than the actual costs incurred plus a 10 percent return on average equity capital, taxpayer is entitled to an additional payment from the department in the amount of the difference.

Therefore, the actual amount (as reflected on the cost report) that must be refunded to the department or paid to the taxpayer, whichever the case may be, is the proper amount that must be accrued by the taxpayer pursuant to sections 1.461-1(a)(2) and 1.451-1(a) of the regulations, respectively. Any adjustment made as a result of the settlement of the desk audit will result in deductions or income in the taxable year in which the settlement is made.

HOLDING

Under an accrual method of accounting, since the actual amount is readily calculable from information on hand at the end of the taxable year (1) the taxpayer must deduct the actual amount (as reflected on the cost report) of the refund, and not an estimate, and (2) the actual amount (as reflected on the cost report) of the additional payment is includible in income in the taxable year in which the related services are performed, not in the taxable year of receipt.

Any change in the taxpayer's method of accounting, from deducting estimated refunds or including additional payments due in the taxable year in which they are received, to the method described in this revenue ruling is a change in method of accounting to which the provisions of sections 446 and 481 of the Code apply.

This ruling is identified as a designated ruling pursuant to section 5.12(2) of Rev. Proc. 80-51, 1980-2 C.B. 818.