IRS challenges Medicare cost deductions for UBIT - Internal Revenue Service; unrelated business income tax - Financial Manager's Notebook - column

Healthcare Financial Management, Sept, 1991 by Elizabeth A. Purcell

Services that many tax-exempt hospitals provide to nonpatients, such as testing referred specimens or operating retail pharmacies open to the public, may constitute unrelated trades or businesses for Federal income tax purposes. (a) Tax-exempt hospitals must pay unrelated business income tax (UBIT) on income generated by these activities. Hospitals report gross income and allowable deductions in computing UBIT on the Internal Revenue Services's (IRS's) Form 990-T. (b)

In computing UBIT on Form 990-T, many tax-exempt hospitals deduct their Medicare costs as reported to the Health Care Financing Administration (HCFA). In General Counsel Memorandum (GCM) 39843, (c) published April 15, the IRS criticized this practice and announced that revenue agents will closely scrutinize and, in many cases, disallow deductions based soley on Medicare costs.

According to the IRS, Medicare costs reported to HCFA and income tax deductions authorized under the Internal Revenue Code (IRC) differ in purpose, definition, allocation, and timing. As a result, deducting Medicare costs to compute an organization's taxable income may distort UBIT in three ways:

* Differences between the definitions of Medicare payment costs and income tax deductions may lead an organization to deduct nondeductible expenses;

* Medicare's step-down method of cost allocation spreads any inaccuracies arising from differences between the definitions of Medicare payment costs and income tax deductions; and

* Timing differences between Medicare cost reporting and tax accounting may distort UBIT.

Allowable deductions

Medicare cost reporting rules are designed to pay hospitals for their reasonable costs in providing services to Medicare beneficiaries. Income tax reporting rules for unrelated trades or businesses are designed to eliminate unfair competition between exempt organizations and taxable businesses.

Under Section 512(a)(1) of the IRC, every deduction must be an allowable deduction "directly connected" to unrelated trade or business and reported in the proper accounting period. Medicare, in contrast, focuses on the relative use of a hospital's services by Medicare patients. Medicare defines costs related to patient care very broadly. Because Medicare costs may include nondeductible expenses and timing differences, deducting Medicare costs in preparing a Form 990-T distorts UBIT.

To deduct any costs on Form 990-T, including Medicare costs, hospitals must prove the costs:

* Are IRC-allowable deductions;

* Are directly connected to unrelated trade or business; and

* Clearly reflect income.

Unless Medicare costs reported on Form 990-T satisfy all three conditions, the IRS will disallow deductions based on those costs. The IRS expects that many Medicare costs will fail one or more of the three tests.

Deductions are allowable in computing UBIT if they meet terms of the definition of deductions in the IRC, such as "ordinary and necessary" business expenses or depreciation, which are defined in Sections 162, 167, and 168. For example, housekeeping costs to clean a retail pharmacy will qualify as an ordinary and necessary business expense. The IRS cautions, however, that to the extent expenses are paid by Medicare, they are not allowable deductions on Form 990-T.

Directly connected deductions

Deductions "proximately and primarily" related to unrelated trade or business are considered directly connected to unrelated trade or business.

For example, hospitals may deduct a reasonable allocation for their overhead expense in connection with unrelated trade or business. (d) Many hospitals copy onto Form 990-T administrative and general (A&G) costs allocated to unrelated trade or business on their Medicare cost reports. The IRS challenges this practice because some A&G costs lack a "direct connection" to unrelated trade or business.

A&G costs, for example, may include costs to perform autopsies or to prepare Medicare cost reports. These costs do not result from unrelated business but from promoting community health, a tax-exempt function. The IRS will expect hospitals to justify deductions of A&G costs as overhead expenses.

The IRS also questions deducting Medicare capital-related costs as depreciation. Capital-related costs include:

* Medicare-defined "depreciation" of hospitals' fixed assets such as buildings; and

* Other costs associated with fixed assets used in patient care, such as insurance and rent. These costs are not the same as depreciation defined in Sections 167(a) and 168 of the IRC. (e)

Capital-related costs involved in promoting community health are not deductions directly connected to unrelated trade or business.

Deductions reflecting income

Hospitals must report allowable, directly connected deductions in the correct taxable year. (f) They must use a method of income tax accounting that "clearly reflects income" from unrelated trades or businesses. Differences exist between accounting methods used for Medicare costs and those allowed for income tax purposes.