Veterinary Medicine - Chapter 2, Industry Issues
Publication Date - April, 2005
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
- Entity Overview
- How to Request a Change in Tax Year Under Revenue Procedure 2002-38
- Method of Accounting
- Balance Sheet Issues
- Income Issues
- Expense Issues
- Constructive Dividends (C Corporations)
- Section 1374 Built-in Gains
- Conversion of a PSC to a Limited Liability Company
- S Corporation Issue: Inadequate Compensation
- Exhibit 2-1
I. Entity Overview
Veterinarians provide their services through sole proprietorships, partnerships, corporations, and limited liability companies. Each entity is subject to unique tax issues, corporations in particular, as described below.
A. Personal Service Corporations
Rev. Rul. 91-30, 1991-1 C.B. 61, as modified by Rev. Rul. 92-65, 1992-2 C.B. 94, holds that a corporation whose employees perform veterinary services is a qualified personal service corporation (QPSC) under Internal Revenue Code (IRC) §§ 448(d)(2) and 11(b)(2) and a personal service corporation (PSC) under IRC § 441(i)(2).
The following tax issues arise from being a personal service corporation and/or a qualified personal service corporation:
- 35 percent corporate rate. Unlike other C corporations, which are subject to graduated income tax rates beginning at 15 percent, a QPSC is taxed at a flat tax rate of 35 percent. See IRC §§ 11(b)(1) and (2).
- Calendar year is required unless permission is granted. Unlike other C corporations, which can adopt a fiscal tax year, a PSC is required to adopt a calendar year unless it can show a valid business purpose. See IRC §§ 441(i)(1) and (2).
- Passive Activity Losses are limited. Unlike many C corporations, which can deduct passive losses against their active income, a PSC cannot offset passive losses against its active income. See IRC § 469(e)(2).
- Accumulated Earnings Tax. A PSC may be subject to accumulated earnings tax if the accumulated earnings and profits exceed $150,000. See IRC §§ 532 and 535(c)(2)(B). The accumulated earnings tax is equal to 15% of the accumulated taxable income, effective for tax years beginning after December 31, 2002.
- Reallocation of income. The IRS can reallocate income and tax attributes to the employee-owners if it determines that the principal purpose for forming the personal service corporation was the avoidance or evasion of taxes. See IRC § 269A(a). This provision applies to a PSC only when substantially all of the services of the corporation are performed for (or on behalf of) one other corporation, partnership, or other entity. See IRC § 269A(a)(1).
Note: IRC § 269A applies when a physician who is an employee of a single hospital, for example, forms a PSC through which to provide services only to that hospital. The statute does not apply to the most common kind of PSC, which is formed in order to provide services to a large number of patients or clients.
B. Personal Service Corporation and Qualified Personal Service Corporations, explained:
- Personal Service Corporation (PSC): The tax law does not provide one sole definition of a PSC. Under IRC § 441, a "personal service corporation" is a C corporation whose principal activity is the performance of personal services and whose personal services are substantially performed by employee owners.
- Qualified Personal Service Corporation (QPSC): To be a QPSC, a corporation must satisfy both a function test and an ownership test as outlined in IRC § 448(d)(2), Temp. Treas. Reg. § 1.448 1T(e)(4), and Temp. Treas. Reg. § 1.448 1T(e)(5).
Substantially all (95 percent or more) of the activities of the corporation must involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. For this purpose, the performance of any activity incident to the actual performance of services in the qualifying field is considered the performance of services in that field. For example, supervising employees who perform qualifying services and performing administrative and support services incident to those activities. See IRC § 448(d)(2)(A) and Temp. Treas. Reg. § 1.448 1T(e)(4).
The examiner should also consider in this determination that a veterinarian may perform activities that are not health service related such as the routine boarding of animals and the sale of pet foods. (See Chapter 1-Description of the Practice of Veterinary Medicine.)
Substantially all (95 percent or more) of the corporation's stock (by value) must be owned directly (or indirectly through one or more partnerships, S corporations, or QPSCs not described in IRC § 448(a)(2) or (3)) by:
- Employees who are performing services that satisfy the function test on the corporation's behalf (for example, a physician performing medical services);
- Retired employees who had performed these services on the corporation's behalf;
- Estates of employees or retired employees who had performed these services on the corporation's behalf; or
- Other persons who acquired stock from employees or retired employees who had performed services on the corporation's behalf (but only for a 2 year period). See IRC § 448(d)(2)(B) and Temp. Treas. Reg. § 1.448 1T(e)(5).
The common parent of an affiliated group (within the meaning of IRC § 1504(a)) may elect to treat all members of that group as a single taxpayer for the purpose of testing whether the ownership test has been met. See IRC § 448(d)(4)(C) and Temp. Treas. Reg. § 1.448 1T(e)(5)(vi).
Refer also to Exhibit 2-1, which includes a letter from the IRS to the American Veterinary Medical Association addressing the taxation of veterinary practices as QPSCs.
A newly-formed partnership, S corporation, or PSC may adopt its required taxable year, a taxable year elected under IRC § 444, or a 52-53-week taxable year ending with reference to its required taxable year or a taxable year elected under IRC § 444 without the approval of the Commissioner pursuant to IRC § 441. If, however, a partnership, S corporation, or PSC wants to adopt any other taxable year, it must establish a business purpose and obtain approval under IRC § 442.
A. IRC § 444 Election
Certain restrictions apply to the IRC § 444 election. A partnership, S corporation, or personal service corporation can elect under IRC § 444 to use a tax year other than its required tax year, but only if the deferral period of the taxable year elected is not longer than the shorter of 3 months or the deferral period of the taxable year being changed.
A partnership and an S corporation with an IRC § 444 election must make required payments under IRC § 7519 that approximate the amount of deferral benefit and a PSC with an IRC § 444 election is subject to the minimum distribution requirements of IRC § 280H. See Required payment for partnership or S corporation in Publication 538 and Rev. Proc. 2002-38, 2002-1 C.B. 1037, as modified by Rev. Proc. 2003-79, 2003-2 C.B. 1036.
Making the Election
Form 8716, Election to Have a Tax Year Other Than a Required Tax Year, is filed by the PSC (as defined in IRC § 441(i)(2)) to elect under IRC § 444 to have a tax year other than a required tax year. The general rules for making an IRC § 444 election are discussed in Publication 538, Accounting Periods and Methods.
B. Obtaining Automatic Approval
Rev. Proc. 2002-38, 2002-1 C.B. 1037, outlines the process by which a partnership, an S corporation, an electing S corporation, or a personal service corporation can obtain automatic approval to change its tax year. In general, automatic approval can be obtained for the following business purposes:
- To change to a required tax year or to a 52-53-week tax year ending with reference to such required tax year.
- To retain or change to a natural business year that meets the 25-percent gross receipts test or to a 52-53-week tax year ending with reference to such natural tax year.
- An S corporation or corporation electing to be an S corporation can get automatic approval to adopt, change to, or retain its ownership tax year or a 52-53-week tax year ending with reference to such ownership tax year.
Treas. Reg. § 1.442-1(b) provides that in order to secure the approval of the Commissioner to adopt, change, or retain an annual accounting period, a taxpayer must file an application, generally on Form 1128, Application to Adopt, Change, or Retain a Tax Year, with the Commissioner within such time and in such manner as is provided in the administrative procedures published by the Commissioner.
In general, an adoption, change, or retention in annual accounting period will be approved where the taxpayer establishes a business purpose for the requested annual accounting period and agrees to the Commissioner’s prescribed terms, conditions, and adjustments for effecting the adoption, change, or retention.
If the taxpayer is using a cash or hybrid method of accounting, an examiner should determine whether the taxpayer is required to use inventory accounting; that is, whether the production, purchase, or sale of merchandise is an income producing factor in the taxpayer's business. If so, the taxpayer must use an accrual method for purchases and sales of such merchandise and any related services.
A. Selection of Proper Accounting Method
An accounting method is a set of rules used to determine when and how income and expenses are reported. The choice of accounting method includes not only the overall method of accounting used, but also the accounting treatment used for any material item.
IRC § 448 requires all C corporations, in general, to use an accrual method of accounting for the first taxable year beginning after December 31, 1986. Note that IRC § 448(b)(2) provides an exception for qualified personal service corporations (QPSC). If a corporation is a QPSC, it is allowed to use the cash method of accounting.
Under IRC § 448(a), a partnership with a C corporation as a partner generally is required to use an accrual method, and a tax shelter must use an accrual method.
Under IRC § 448(b)(3), a C corporation or a partnership with a C corporation partner may use the cash method if it meets a $ 5 million (or less) gross receipts test. See IRC § 448(c) and Temp. Treas. Reg. §§ 1.448-1T(f)(1) and (2) for details on this exception.
Note: A QPSC is permitted to use the cash method of accounting. If the corporation in any year fails either the function test or the ownership test,, it is no longer a QPSC; consequently, it is required to change to an accrual method of accounting. The one exception to the mandatory change is the not more than $5,000,000 gross receipts test. See Temp. Treas. Reg. § 1.448-1T(f)(2).
Finally, a taxpayer chooses an accounting method when the first tax return is filed. Afterward, permission must be received from the Commissioner of Internal Revenue in order to change it. See "Changes in Accounting Methods," later.
There are three main methods of accounting that may be used by veterinarians: the cash method, an accrual method, and a hybrid method.
Most sole proprietors, PSCs and partnerships with no inventories use the cash method of accounting. However, if inventories are necessary in accounting for income, then the accrual method for sales and purchases is required under IRC § 471, with certain exceptions, discussed in the next section. With the cash method, all items of income actually or constructively received during the year are included in gross income. This includes the fair market value of property and services received. Usually, expenses are deducted in the tax year in which actually paid.
Under an accrual method of accounting, income is generally reported in the year earned, even though payment may be received in another tax year. Items are included in gross income in the tax year in which all events occur that fix the right to receive the income, and the amount can be determined with reasonable accuracy. Business expenses are deducted or capitalized when the liability is incurred, whether or not they are paid in the same year. For this purpose, the liability is recognized in the tax year in which both the "all events" test and the economic performance rules of IRC §§ 461(a) and 461(h) are met. The purpose of an accrual method of accounting is to match income and expenses in the correct year.
Relief from the Accrual Method - Small Businesses Exceptions:
Under Rev. Proc. 2001-10, 2001-1 C.B. 272, certain businesses required to use inventories and account for purchases under the accrual method may use the cash method if the average annual gross receipts are $ 1 million or less. Inventory amounts under this exception are treated as non-incidental materials and supplies under the rules of Treas. Reg. § 1.162-3.
Further, Rev. Proc. 2002-28, 2002-1 C.B. 815, expanding upon Rev. Proc. 2001-10, allows certain qualifying small business taxpayers (as defined in Rev. Proc. 2002-28 section 5) with average annual gross receipts of $ 10 million or less to be exempted from the requirement to use the accrual method of accounting under IRC § 446 and to account for inventories under IRC § 471. According to Rev. Proc. 2002-28, inventory items are accounted for as materials and supplies under Treas. Reg. § 1.162-3. Eligible businesses include those taxpayers whose principal business is the provision of services and includes veterinary businesses.
The hybrid method is the use of any combination of cash, accrual, and special methods of accounting if the combination clearly reflects income and is used consistently. However, the following restrictions apply:
If inventories are necessary to account for income, then the accrual method must be used for purchases and sales of inventory items. An accrual method must also be used to account for the receipts from services that are intertwined with the sales of inventory items. The cash method may generally be used for all other items of income and expenses.
If the cash method for reporting expenses is used, then the cash method for computing income must also be used. If an accrual method for reporting expenses is used, then that accrual method must also be used for figuring income.
Use of the hybrid method of accounting in a veterinary practice could include reporting the sale of veterinary products that are not provided in connection with services on the accrual basis and reporting the veterinary services and de minimis merchandise provided in connection with such services under the cash method. Treas. Reg. § 1.446 1(c)(1)(iv) recognizes that a combination of methods of accounting may be permitted in connection with a trade or business if such combination clearly reflects income and is consistently used.
A hybrid method might clearly reflect income if:
- The merchandise provided incident to services is de minimis;
- The other veterinary products sold by the taxpayer are severable from the services and related de minimis merchandise; and
- The taxpayer keeps its books and records in such a way that the purchase and sale of veterinary products can be separated from the sales of services and de minimis merchandise (for example, the taxpayer bills separately for the veterinary products, and the mixed services and de minimis merchandise, and, to the extent common payments are received, they are reasonably allocated between the separate bills).
A taxpayer using a hybrid method of accounting may operate as a single trade or business and may maintain a single set of books and records for such business.
B. Is Merchandise an Element in the Taxpayer's Business and Is It Income Producing?
The first step in this analysis is to determine whether the taxpayer has "merchandise." At this stage, it is important to distinguish between merchandise for sale and material/ supplies. The term "merchandise" is not defined within the Code or underlying regulations. However, in Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352, 354-55 (1st Cir. 1970), the court, after canvassing authorities in the accounting field for definitions of the term, found that the common denominator among the various definitions was that an item is merchandise if held for sale. Based on the regulations and the case law, the Service has determined that, for purposes of Treas. Reg. § 1.471 1, merchandise is property transferred to a customer (including property physically incorporated in that which is transferred to a customer), whereas materials and supplies are property consumed during the production of property or provision of services.
The next step in the analysis is to determine whether the production, purchase, or sale of such merchandise is an income-producing factor in the taxpayer's business. In cases involving the provision of services and the transfer of related merchandise by a taxpayer, the courts have generally compared the cost of the merchandise purchased to the taxpayer's cash method gross receipts. There is no bright line test with respect to when merchandise will be regarded as an income-producing factor in a taxpayer's business. However, courts have found that merchandise is an income-producing factor in a taxpayer's business where its cost is approximately 15 percent of the taxpayer's cash method gross receipts. See, e.g., Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d at 355.
Below are some steps which may help determine if a veterinarian has inventory which is income-producing:
1. Analyze purchases. Purchases must be analyzed to determine what is bought throughout the year, and whether the purchased items are transferred to the veterinarian's customers. A small year end balance is not an indication that inventory is insignificant and need not be considered. It also does not matter whether the customer is charged separately for items such as prescription drugs, which may be delivered at the same time as the service or at a later date.
If an item is consumed in the course of providing a service, it is more akin to a supply and such items are accounted for as materials and supplies under Treas. Reg. § 1.162-3. Some examples of supplies are: alcohol, whippets, combs, tongue depressors, disposable syringes, rubber gloves, and like items. These can be accounted for as materials and supplies under Treas. Reg. § 1.162-3.
In addition, certain court cases have held that the furnishing of pharmaceuticals by a medical treatment facility was so integrated in the rendering of the medical service that such drugs did not have to be inventoried. See Osteopathic Medical Oncology and Hematology, P.C. v. Commissioner, 113 T.C. 376 (1999), acq. in result, 2000-23 I.R.B. 2, and Mid-Del Therapeutic Center, Inc. v. Commissioner, T.C. Memo. 2000-130, aff’d, 89 A.F.T.R.2d 2002-1106, 2002-1 USTC 50,245.
However, if the same medical supplies or drugs listed above are sold separately to the veterinarian's customers, they may constitute inventory.
2. Compare purchases with gross receipts. The cost of the inventory items purchased during the year should be compared with the taxpayer's cash method gross receipts in order to determine whether the production, purchase, or sale of merchandise is an income-producing factor in the taxpayer's business.
Note: Veterinarians are required to maintain inventory records on some controlled substances by the U.S. Drug Enforcement Agency and state drug enforcement agencies. A review of those records may be helpful in verifying balances.
If you determine that the taxpayer is required to account for inventories and the taxpayer has no records that indicate the beginning and ending inventory values, have the taxpayer conduct a current inventory. Question the taxpayer closely as to any extraordinary circumstances that might have affected this value during the year under examination. If no unusual circumstances exist, then use the current value as both beginning and ending inventory value. In this example, your adjustment would be to increase income by the amount of the opening inventory amount under IRC § 481(a). (See Accounting Method discussion, below).
If the production, purchase, or sale of merchandise is an income-producing factor in the veterinarian's business, propose that the taxpayer change from cash to an accrual method of accounting after considering all revenue procedures (discussed above) which provide relief from using the accrual method.
If the taxpayer keeps its books in such a way that the sale of merchandise is severable from the sale of services, propose a change to a hybrid method of accounting.
C. Handling Changes of Accounting Methods
Examiners can refer any issue dealing with accounting method changes to the Accounting Method Changes Technical Advisors in the Large and Midsize Business Division (LMSB).
The examiner has the authority to change a taxpayer’s method of accounting when no method has been used regularly or when the method used does not clearly reflect income. IRC § 446(b). The examiner also has the authority to select a proper method, and the selection may only be challenged by showing there was an abuse of discretion. See Wilkinson-Beane, Inc. v. Commissioner, T.C. Memo. 1969-79.
Examples of method change issues that may be raised during an examination include:
- Changing from cash to accrual method as required by IRC § 448.
- Expensing items required to be capitalized under IRC § 263 or § 263A.
- Changing the timing of accrual under IRC § 451 or IRC § 461.
In general, voluntary changes are initiated by the taxpayer by filing a Form 3115, Application for Change in Accounting Method, referring to the directions therein.
Involuntary changes (i.e. those proposed by Examiners) are covered by Revenue Procedure 2002-18, 2002-1 C.B. 678, which provides guidance to examiners initiating accounting method changes. Section 2.03 of the procedure states that the “taxpayer does not have a right to a retroactive change, regardless of whether the change is from a permissible or impermissible method.” Accordingly, the examiner is not obligated to consent to a retroactive change in accounting method requested by the taxpayer either by a formal or informal claim. However, if the examiner initiates a change in accounting method issue that, upon development, results in a taxpayer favorable result, the examiner should follow through using the Service initiated change procedures.
Typical balance sheet audit issues and techniques are found at IRM 220.127.116.11, in addition to the exam techniques found at IRM 18.104.22.168 for Schedules M-1 and M-2. Following are industry specific issues that examiners could encounter.
1. Customer/Medical records
Customer/medical records usually include the veterinary history, a record of visitations, treatments performed by the veterinary practice, test results, charts, X rays, as well as other billing information. The cost of creating and maintaining such a record is expensed as part of salaries, supplies, and other incidentals that are allowed as ordinary and necessary business expenses under IRC § 162.
Customarily when a veterinary practice is sold, a value is assigned to the customer/medical records and the purchasing party, for book purposes, will either depreciate or amortize the records over a period of time (which may be straight line for 60 months). However, for tax purposes, customer/medical records are intangibles within the meaning of IRC § 197 and are subject to the 15-year amortization rules (see Publication 535 chapter 9).
2. Purchase of a veterinary practice
An issue that may be present is the overvaluation of tangible assets and the undervaluation of intangible assets, which accelerates the purchaser's recovery of its costs through depreciation deductions for assets with shorter recovery periods. A change to the allocation of basis between intangible and tangible assets, the result of which simply changes the time or period over which the costs of the assets are recovered or taken into account, is a change in method of accounting to which the provisions of IRC §§ 446 and 481 generally apply.
B. Loans to Shareholders
As with other closely held corporations, loans to shareholders have potential for audit adjustment to both the corporation and the shareholder. Loans to shareholders may include advances paid in varying amounts over a continuing period. The personal expenses of the shareholder paid by the corporation may be charged to the account. In many instances, there may be no interest charge. Loan agreements should be reviewed to determine if a bona fide creditor debtor relationship exists between the corporation and the shareholder.
1. Potential imputed interest
Adjustment per IRC § 7872. Check to see if the balance is $10,000 or greater (the de minimis threshold amount) on each and every day of the year before applying IRC § 7872. The de minimis exception does not apply where tax avoidance is a principal purpose of the below market loan.
2. Loan or a dividend distribution
Beginning and ending balances should be verified to determine if a pattern of continually increasing balances is occurring. Even when bona fide loan agreements exist, such increases may represent dividends to the shareholder. If a distribution that was originally classified as a loan is in fact deemed not to be a bona fide loan, the amount will be considered to be a constructive dividend.
Customers pay in cash
Most health care providers receive the majority of their income from third party payers (insurance companies). Veterinary service is one of the exceptions. Customers, for the most part, are responsible for making payments directly to the veterinarian for services performed. Large numbers of small animal and mixed animal customers may pay for their services in cash.
Audit experience indicates that many veterinarians maintain computerized billings and cash receipt information, which can quickly and accurately provide information as to any customer's balance. This information is typically maintained on site and can be produced in many ways; that is, cash receipts journals segmented by day, week or month; customer ledger cards detailing individual charges; payments and adjustments; or accounts receivable lists. However in spite of the modern record keeping systems available, many choose to report gross receipts per the bank deposit method. When cash is not deposited or when checks are cashed or deposited into an account other than the business account, this method of reporting income is not accurate.
Interviews with return preparers who have been found to rely on bank deposits to reconcile gross receipts (which in most cases understates income) indicated that they were unaware of the computerized record keeping systems. These preparers provide only year-end compilation rather than complete income analysis of services rendered by the veterinary practice. They have indicated that when they question their clients as to their deposit characteristics and are told that all gross receipts are deposited into the business bank account, the preparer confidently uses the bank statements to report income. Rarely are any adjustments made to the gross deposits shown on the bank statements.
Check for unreported receipts. Many personal checks are received as payment for services. If the practice is a corporation or sole proprietorship, many of the checks will be made to the veterinarian personally. It would not be difficult to cash these checks or divert them into personal bank accounts.
Based on this discussion, business income can easily be diverted from being deposited into the business bank account(s) and reported on the tax return. Therefore, it is imperative that each examination includes alternative methods of determining gross receipts. The use of patient billing records, accounts receivable ledgers, and patient sign in registers are examples of other sources.
Note: The IRM provides guidelines for expanding the scope of examinations to include the veterinarian's personal bank accounts and the evaluation of the veterinarian’s financial status.
A. Gross Receipts
1. Analyze the duplicate deposit slips. In general, there should be frequent and significant cash deposits.
2. Analyze the day sheets. The total collections per the day sheets should equal the gross receipts per the tax return.
3. Analyze the customer account ledger cards. Select a sample and trace the entries on the customer account ledger cards to the day sheets.
4. Analyze the charge slips. It is possible to pull the customer account ledger cards that one doesn't want the examiner to see.
5. Analyze the appointment book and/or sign in sheet. If these books show that 25 customers came in on a certain day, there should be 25 charge entries on the taxpayer's day sheets.
6. Analyze business cash pay outs. Verify that the income was reported before it was paid out for business expenses.
B. Additional Income Issues
1. Sale of the veterinary practice
Many issues can arise from the sale of a medical practice. Among them is how to handle the outstanding accounts receivables. The contract for sale must be secured and inspected in order to consider the various issues (including proper income recognition) that may be present.
2. Passive income recharacterization
a. Per IRC § 469(a)(2)(C), a PSC is subject to the passive activity loss rules.
b. Self Rented Real Estate – It is a common practice for a veterinarian to own the building personally (or sometimes in partnership) and to lease it to the PSC. In this scenario, the net rental income is recharacterized as nonpassive income under Treas. Reg. § 1.469-2(f)(6) and should not be reflected on Form 8582, Passive Activity Loss Limitations, line 1a, where it would improperly trigger otherwise nondeductible passive losses.
Does the taxpayer materially participate in the entity renting from the taxpayer? The answer is almost always yes.
If the answer is “yes”, the rental income should be treated as nonpassive and should not be reflected on Form 8582.
- Is rent at a fair market value?
- Is there any personal use of the building space?
c. Self Rented Equipment: Net losses are generally passive under IRC § 469 (c)(2) and (4) whether or not the taxpayer materially participates. Thus, losses are not deductible in the absence of passive income. Net income is nonpassive under Treas. Reg. § 1.469-2(f)(6).
- Is rent at a fair market value?
- Is there any personal use?
Reminder: Bare equipment leases are subject to self employment tax. IRC § 1402(a)(1) excepts real estate, but not bare equipment leases. Also, see Stevenson v. Commissioner, T.C. Memo. 1989 357.
d. Self Charged Interest
- Did the taxpayer loan money to a flow through entity?
- Did the entity pay interest to the taxpayer and claim a deduction for interest expense for all or part of the amount paid?
- Did the entity use any part of the loan proceeds in a passive activity?
If each answer is yes, the taxpayer has self charged interest income that should be recharacterized from portfolio income to passive income per Treas. Reg. § 1.469 7(a)(1)(i) and (c). This rule is generally beneficial to the taxpayer. However, the interest income that is recharacterized as passive cannot be used as investment income on Form 4952, Investment Interest Expense Deduction. Thus, there may be an adjustment to allowable investment interest expense. Investment interest is deductible only to the extent of investment income under IRC § 163(d).
IRM 22.214.171.124 provides general guidelines in the audit of Cost of Goods Sold expenses while IRM 126.96.36.199 provides audit technique guidelines in the audit of operating expenses.
In addition to considering the typical large and unusual expense items in an audit, below are certain expense issues encountered in a veterinary audit.
A. Lease versus Purchase
In a veterinary practice, many assets can be leased rather than purchased, including tables, chairs, desks, and x ray equipment. Many lease agreements have an option to purchase the assets at the end of the lease term for a nominal price. These types of leases should be treated as a purchase and the assets should be depreciated by the veterinary practice.
Court cases and IRS rulings have reached determinations on whether a lease is a "valid" lease based on the substance and not the form of the transaction. See Lockhart Leasing Co. v. U.S., 446 F.2d 269 (10th Cir. 1971); Rev. Rul. 55 540, 1955 2 C.B. 39.
Factors in Rev. Rul. 55 540 that indicate a sale rather than a lease include:
1. The lessee acquires title after making a stated number of payments.
2. The lessee's payments for a short term of use are a large part of the payment necessary to secure a transfer of title.
3. Rent payments exceed fair rental value.
4. The lessee has a purchase option at a nominal price.
5. Some portion of the rental payments is identifiable as interest.
Tax consequences that may apply if a lease is determined to be a sale:
1. The lessor must report a gain or loss on the transaction.
2. The lessee cannot deduct rental payments.
3. The lessee is allowed to deduct depreciation and interest expenses on the property.
4. The lessee's basis in the property will be the sum of all payments made pursuant to the lease (excluding payments that represent interest or other charges).
A change from improperly treating property as leased by the taxpayer to treating such property as purchased by the taxpayer, or vice versa, is a change in method of accounting to which the provisions of IRC § 446 apply. Further, the provisions of IRC § 481 generally apply when such a change is made by the examiner as part of an examination.
B. Automobile Expense
A veterinarian's trips between a residence and a hospital or the office are considered commuting, and the transportation expenses are personal, unless the residence qualifies as a home office for the veterinary business under IRC § 280A(c)(1)(A). See Rev. Rul. 99 7, 1999 1 C.B. 361.
C. Entertainment, Travel, and Meals
IRC § 274(d) provides explicit substantiation requirements for entertainment, travel, and meal expenses. However, even if the expenses are substantiated, they must be ordinary and necessary business expenses. Entertainment expenses must be clearly related to the production of business income.
Note that no deduction is allowed for membership in clubs organized for business, pleasure, recreation, or other social purposes under IRC § 274(a)(3) for amounts paid after December 31, 1993. Also, IRC § 274(n) generally disallows 50 percent of otherwise deductible entertainment expense and food and beverage expenses.
Constructive dividends can take many forms, such as excessive compensation, loans to shareholders, payments for the shareholder's benefit, shareholder use of corporate property, and bargain purchases. Some typical fringe benefits include automobile allowances or use of a corporate automobile, cellular phone or other communications equipment, tuition remittances, insurance, free or discounted membership in clubs, housing allowances, educational assistance, travel benefits, and free or below market loans. In all cases, however, a dividend is not declared unless the transaction is deemed to be for the personal benefit of the shareholder rather than the corporation. Some transactions commonly reclassified as dividends are summarized below. Most adjustments for constructive dividends to veterinarians will occur in the payments for shareholder's benefit and the loans to shareholders categories.
Note: Remember that a corporate distribution is a dividend only to the extent of earnings and profits.
A. Loans to Shareholders
One method of avoiding any type of taxable distribution to the shareholder is a loan from the corporation. If a distribution that was originally classified as a loan is in fact deemed not to be a bona fide loan, the amount will be considered a constructive dividend.
B. Payments for the Shareholder's Benefit
If the corporation pays the personal obligations of the veterinarian/shareholder, the payment may be treated as a constructive dividend based on the purpose of the expenditure. Some examples of constructive dividends that arise from a payment for the veterinarian/shareholder are personal debt, medical expenses, travel and entertainment expenses, personal use of a corporate automobile, and family members' wages when no bona fide services are performed. A corporation may allow the veterinarian/shareholder to receive money through the year and reclassify the payments from loan to wages at year-end. If there is no agreement for the payment of bonuses in this manner, the distribution may be deemed a dividend.
C. Excessive Compensation/Rents/Interest
When a corporation pays a veterinarian/shareholder compensation that is deemed excessive for the services provided, that portion considered unreasonable is treated as a constructive dividend. Similarly, excessive payments for the corporate use of shareholder property, for example, excessive rents and interest, may also give rise to a constructive dividend.
1. Determine the total compensation paid or accrued to the principal officers, taking into consideration any compensation claimed under headings other than officer's salaries, such as labor, contributions to pension plan for the officers, payments of personal expenses, and year end or other bonuses.
2. Determine if and to what extent each principal officer's compensation is unreasonable by taking into account the following factors: nature of duties, background and experience, knowledge of the business, size of the business, individual's contribution to profit making, time devoted, economic conditions in general, character and amount of responsibility, time of year compensation is determined, relationship of the stockholder/officer's compensation to stockholdings, whether alleged compensation is in reality, in whole or in part, payment for a business or assets acquired, and the amount paid by similar size businesses in the same area to equally qualified employees for similar services. Also, see the section on Inadequate Compensation in this chapter.
D. Shareholder Use of Corporate Property
Constructive dividends can also occur when a veterinarian/shareholder uses corporate property for personal purposes at no cost. The most common dividend in this category is the use of a company car. Of course, use of other company owned property such as boats, airplanes, entertainment facilities, and vacation homes may also generate dividend treatment. The taxpayer may avoid dividend treatment by having the shareholder reimburse the corporation for any personal use of the property or by including the value of such benefits in the veterinarian/shareholder's income as compensation.
E. Bargain Purchases
Corporations often allow shareholders to purchase corporate property at a price less than the property's fair market value. An example of this could be the purchase of animals or bulk feed. These so called bargain purchases are treated as constructive dividends to the extent the fair market value of the property exceeds the amount paid for the property by the veterinarian/shareholder or a family member. See Treas. Reg. § 1.301-1(j). In the case where the distributed property (in a bargain purchase by the shareholder) is “appreciated property” (the corporate property’s fair market value exceeds its adjusted tax basis), gain is also recognized at the corporate level. See IRC § 311(b).
A. Tax on Built In Gains - IRC § 1374
Virtually all medical PSCs have substantial amounts of accounts receivable. Since their tax returns are filed on the cash basis, the receivables are not recognized for tax purposes until the payments are received. Under IRC § 1374, when C corporations elect S status after 1986, the built in gains tax applies to the receivables that accrued when they were C corporations but were paid during the recognition period. The recognition period is the 10-year period beginning with the first day of the first taxable year for which the corporation was an S corporation or the day on which the S corporation acquires assets from a C corporation in a carryover basis transaction.
Questions to consider:
1. Was it a C corporation prior to making its S corporation election?
2. Was the S corporation election made after 1986?
3. Does it have a net recognized built in gain within the recognition period?
4. Check to see that the net recognized built in gain for the tax year does not exceed the net unrealized built in gain minus the net recognized built in gain for the prior years in the recognition period that were subject to tax.
The amount of tax imposed is computed by applying the highest rate of tax specified in IRC § 11(b) to the net recognized built in gain of the S corporation for the taxable year. If there is a net operating loss from a C year, then the NOL carryforward will be allowed as a deduction against the net recognized built in gain. If there is a credit carryforward under IRC § 39, the carryforward amount will be allowed as a credit against the tax.
B. Whipsaw Issue
If you impose an IRC § 1374 tax on the corporation, you must also allow a corresponding deduction on the shareholder's personal return under IRC § 1366(f)(2).
The basic aim of this tax is to prevent a corporation from accumulating income in order to shelter its stockholders from the individual income taxes that they would pay if the corporation's income were distributed to them as dividends. Therefore this tax is imposed on corporate earnings and profits that are accumulated in excess of reasonable business needs. Some accumulation is allowed without the risk of additional tax liability, but amounts in excess of $150,000 for service type corporations should be examined to determine if the intent is a tax avoidance scheme of deferment of stockholder income.
To review this issue, it is generally helpful to effect a reconciliation of the surplus shown in the books to the earnings and profits available for tax purposes. Look for transfers to capital or other accounts in the form of stock dividends or reserves (which do not qualify as write downs of earnings and profits), receipt of life insurance, or write downs of purchased goodwill or other intangible assets.
Many PSCs might prefer to organize as a Limited Liability Company (LLC) because of the greater flexibility afforded LLCs. Presently, PSCs must pay a corporate tax at the highest corporate rate without the advantage of graduated rates. There are special classification issues for PSCs as to whether they can use the cash method of accounting or elect to use an IRC § 444 fiscal year. These classification issues could be avoided by moving into LLC status.
Converting to an LLC may be relatively easy for the single owner PSC. In these situations, the PSC probably pays little if any corporate tax because earnings are paid out as deductible compensation to the shareholder/employee.
The most substantial asset that the PSC has is its accounts receivable and possibly a partnership interest in a lower tier partnership. Under the cash method of accounting, distribution of the receivables would trigger an IRC § 336 gain on liquidation to the extent of the fair market value of the zero basis receivables. Thus, rather than liquidating immediately, the receivables could be retained in the PSC until they are collected and income is recognized. Any cash would then be paid out in the form of compensation and the corporation could then be liquidated without any further tax (unless there is a partnership interest distributed).
Note: Costs for converting a PSC to an LLC (that is, legal fees) should be capitalized. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992). Also consider Treas. Reg. § 1.263(a)-4, which details rules on capitalization or expensing of amounts paid or incurred for certain intangible assets on or after December 31, 2003.
In a C corporation, excessive compensation may be paid to shareholder/employees as a means to avoid paying the second-tier tax on dividends. Because S corporation distributions of earnings are generally not subject to second tier tax on dividends, whether a shareholder has received excessive compensation is generally irrelevant. Therefore, the issue of inadequate compensation to a shareholder/officer in an S corporation examination may be an issue, resulting in an employment tax case. See Veterinary Surgical Consultants, P.C. v. Commissioner, 117 T.C. 141 (2001).
To evaluate the income of US veterinarians, see JAVMA, Vol. 222, No.12, June 15, 2003, for the Veterinarian Industry Compensation rates, which provide information related to the industry compensation rates. Remember that this survey is only a guide, not an absolute standard, and may have later updates.
2000-2004 American Veterinary Medical Association
All rights reserved
January 1, 2001 (Volume 218, No. 1)
Small Business Concerns
Clarification of C-corporation classification of veterinary corporations
During the 2000 Annual Session of the AVMA House of Delegates, the Council on Veterinary Service and the California Veterinary Medical Association submitted a resolution requesting that the AVMA pursue a Technical Advice Memorandum (TAM) from the Internal Revenue Service. The intended purpose of the desired TAM was to allow veterinary corporations with more than 5% of their gross income from non-professional sales to be classified as regular C corporations for income tax purposes, rather than as qualified personal service corporations (QPSC). Currently, veterinary C corporations that meet certain ownership and function tests are required to file as QPSC. Qualified personal service corporations are taxed at a flat rate of 35% of taxable income, whereas regular C corporations are taxed at a graduated rate beginning at 15% and increasing to 35%.
Following extensive discussion and recognizing technical problems in the language of the proposed resolution, the House of Delegates referred the issue to the AVMA Executive Board. The Executive Board referred the matter to the Legislative Advisory Committee (LAC) for consideration.
In preparation for the October meeting of the LAC, AVMA staff and officers met twice with IRS personnel. During the second of these meetings, IRS personnel delivered a letter (see pp 23-24) to the AVMA that they believed would address the veterinary profession's concerns. The language of the underlying regulations does not allow the IRS to accept the premise that the percentage of income from non-professional sales and services can be used as an accurate reflection of the percentage of time spent in non-professional activities. However, the letter did clarify some of the criteria that affect the ownership and function tests used to determine whether a veterinary corporation is classified as a QPSC.
With regard to the ownership test, if more than 5% of a corporation's stock is owned by a spouse, family member, or another individual who is not employed by the corporation, the corporation fails the ownership test and is not a QPSC. However, further clarification of the ownership test may be needed for corporations in community property states.
With regard to the function test, if more than 5% of the time spent by the corporation's employees is spent in activities that are not directly involved in the performance of professional services or the performance of activities incidental to those services (such as supervision of employees providing services, completion of administrative duties, and provision of support services), the corporation fails the function test and is not a QPSC. In this regard, the IRS does not consider boarding and grooming of healthy animals, retail sale of pet food and pet products, and dispensing of prescription or over-the-counter pharmaceuticals to be a necessary part of the performance of veterinary services, and time spent by the corporation's employees in such activities is considered time that is not directly involved in the performance of professional services. For example, the IRS representative stated that because prescription drugs can be obtained from pharmacies and other sources, sales of these products are not considered necessary to the practice of veterinary medicine.
It is important to remember, however, that the function test is based on time spent in qualifying (activities directly involving the performance of services) versus non-qualifying (activities not directly related or necessary to the performance of services) activities, and not to the relative income from them. To verify what percentage of time is spent by the corporation's employees in performing qualifying activities and what percentage is spent performing non-qualifying activities, some contemporaneous record of how time is spent is required. However, IRS personnel have emphasized that this record-keeping need not be onerous, and the IRS is willing to consider any reasonable method.
During the meetings with IRS personnel, additional written questions were submitted, and AVMA staff anticipates further correspondence from the IRS with responses to those questions. In the meantime, the IRS has stated that its letter to the AVMA can be cited as an official source document. Veterinarians should consider this important new information carefully and share it with their tax consultants as they plan their tax strategies.—Dean E. Goeldner, DVM, Assistant Director, AVMA Governmental Relations Division (© 2000-2004 American Veterinary Medical Association. All rights reserved)
September 27, 2000
American Veterinary Medical Association
1101 Vermont Avenue, NW, Suite 710
Washington, DC 20005-3521
This letter is written in response to your request for reconsideration, or possible revocation, of Revenue Ruling 91-30, which designates veterinarians as personal service providers. The request was prompted by the settlement of an income tax case in which a veterinarian established that his corporation was not a qualified personal service corporation (QPSC) and, therefore, was not subject to the 35% tax rate under Internal Revenue Code 11(b). We appreciate your bringing this case to our attention and your concern for the equitable and consistent treatment of taxpayers within the veterinarian profession. My research of tax returns filed by veterinarians during 1999 indicates that this issue may possibly affect approximately 12% of the population, which file corporate returns. (20% file as S-corporations, 5% file as partnerships, and 63% file as sole proprietorships.)
Generally, under Code section 448, corporations cannot use the cash method of accounting to compute taxable income. However, there is an exception allowing corporations providing personal services to use the cash method if specific conditions are met.
First, the personal services must be in one of eight professions, including the fields of health, law, engineering, architecture, accounting, actuarial science, the performing arts, and consulting. By virtue of Revenue Ruling 91-30, veterinarians are members of the healthcare profession.
Second, there is an ownership test. Substantially all (95%) of the corporation's stock must be owned by the employees providing the services for the corporation. Collectively, "employees" include current employees, retired employees, estates of employees, and individuals who acquired stock by reason of death of an employee.
Finally, there is a function test. Substantially all (95%) of the corporation's activities must involve the performance of services. This means that 95% of the time spent by employees of the corporation is devoted to the actual performance or supervision of the qualifying services, administrative duties or support. In the veterinarian's case, he appealed the examiner's findings and presented his argument to an Appeals Officer, who has authority to arbitrate the issue. The appeal process is informal and is intended to alleviate the burden of presenting the case before Tax Court. He convincingly argued that specific services and the retail sale of pet products were non-service business activities and were not incidental to the performance of veterinary healthcare services and (2) that annual gross revenue was the most accurate measure of time spent by the corporation's employees.
The veterinarian's settlement is specific to his case and cannot be used as a basis for determining tax policy. We can, however, reconsider each of the three criteria used to define qualified personal services as they are applied to veterinarians.
I. Designated Profession
Revenue Ruling 91-30, specifically includes veterinarians as members of the healthcare profession. In fact, the first paragraph of the current audit technique guide starts with the statement that doctors of veterinary medicine are medical professionals, whose primary responsibility is protecting the health and welfare of animals and people. It would be difficult to support the reversal of Revenue Ruling 91-30.
However, another aspect of IRC 448 needs to be considered. This Code section was enacted to limit the use of the cash method of accounting by corporations, but qualified personal service corporations are excepted from this restriction under IRC 448(b)(2). If veterinarian practices lose their status as qualified personal service corporations, it may be necessary for them to use the accrual method of accounting for all their activities; i.e., hybrid cash and accrual methods may not be allowable. Alternatively, Rev. Proc. 2000-22 provides that qualifying taxpayers with average annual gross receipts of $1,000,000 or less are excepted from the requirement to use an accrual method of accounting. This determination is made each year and, if the taxpayer ceases to qualify for the exception, they must change to an inventory method.
II. Ownership Test
95% of the corporation's stock must be owned by the employees providing the services for the corporation. As stated earlier, "employees" include current employees, retired employees, estates of employees, and individuals who acquired stock by reason of death of an employee. A corporation's stock is considered held "indirectly" by a person if, and to the extent that, such person owns an interest in a partnership, "S" Corporation, or another qualified personal service corporation, that owns stocks in the corporation. However, other forms of indirect stock ownership, such as familiar attributions, are not considered. Therefore, non-employee spouses, parents or children of an owner-employee could own more than 5% of the corporate stock and the corporation would fail the ownership test. (See Regulation 1.448-1T (e) (5) (vii), Example 6.)
III. Function Test
95% of the corporation's activities must involve the performance of services. This means that 95% of the time spent by all the employees of the corporation is devoted to the actual performance of the qualifying services and any incidental activities such as supervising employees who are providing the services, administrative duties, and support services. Non-qualifying activities include (but are not limited to) the retail sale of pet supplies or medications, and the boarding or grooming of animals not under the veterinarian's medical care. Therefore, if more that 5% of the time spent by all employees is dedicated to non-qualifying activities, the corporation is not a qualified personal service corporation.
If an incorporated veterinarian practice does meet the stock ownership and function tests, the impact of higher tax rates for qualified personal service corporations can be limited by paying out reasonable wages to the employee. The corporation's taxable income will be reduced and the income will be shifted to personal returns subject to graduated tax rate. While this is an acceptable practice, a cautionary note must be emphasized. When the corporation's taxable income is reduced by paying out wages, there may be an issue of excessive compensation. (See audit technique guide, pages 4-22 through 4-28.) It will also be necessary to carefully consider dividend distributions.
It appears that there are alternatives for veterinarians filing corporate returns to address issues regarding their designation as qualified personal service corporations. However, only the corporate officers can decide what is best for them individually and I would recommend that they consult with a tax professional before making any decisions.
We hope this information will be of assistance to you. If you have any questions, please feel free to call xxxxx xxxxxxxxx, of my staff, at xxx-xxx-xxxx.
xxxxxxx x. xxxxxx
Manager, Market Segment Strategies
Editor's note: xx. xxxxxxxxx can also be reached by e-mail at email@example.com