Osteopathic Med. Oncology & Hematology, P.C. v. Comm'r of Internal Revenue

• Decision Date: 22 November 1999
• Docket Number: No. 11551–98.,11551–98.
• Citation: 113 T.C. 376,113 T.C. No. 26
• Parties: OSTEOPATHIC MEDICAL ONCOLOGY AND HEMATOLOGY, P.C., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

113 T.C. 376

113 T.C. No. 26

OSTEOPATHIC MEDICAL ONCOLOGY AND HEMATOLOGY, P.C., Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

No. 11551–98.

United States Tax Court.

Nov. 22, 1999.

P, a professional service corporation, specializes in the treatment of cancer through chemotherapy. P uses drugs and ancillary pharmaceuticals (collectively, the drugs) during its treatment. The chemotherapy treatments are prescribed by P's professional staff, and patients do not select the type or quantity of drugs used during the treatments. P uses the cash method to expense the cost of the drugs. R determined that the drugs were “merchandise” under sec. 1 .471–1, Income Tax Regs., and that P must use an accrual method to report all amounts attributable to the drugs.Held: The inherent nature of P's business is that of a service provider, P's use of the drugs is subordinate to the provision of its services, and P uses the drugs as an indispensable and inseparable part of the rendering of its services; thus, the drugs are not “merchandise” under sec. 1.471–1, Income Tax Regs., and P properly used the cash method to expense the drugs' cost.David C. May, for petitioner.

Grant E. Gabriel, for respondent.

OPINION

LARO, J.

The parties submitted this case to the Court without trial. See Rule 122. Petitioner petitioned the Court to redetermine respondent's determination of a $50,515 deficiency in its 1995 Federal income tax. The sole issue for decision is whether petitioner, a professional service corporation, may use the cash receipts and disbursements method (cash method) to expense the drugs and ancillary pharmaceuticals (collectively, chemotherapy drugs) used by it while providing chemotherapy treatments to its patients. We hold it may. Unless otherwise stated, section references are to the Internal Revenue Code as applicable to 1995, and Rule references are to the Tax Court Rules of Practice and Procedure.

Background

All facts are stipulated and are so found. The stipulation of facts and exhibits submitted therewith are incorporated herein by this reference. Petitioner's principal place of business was in Clinton Township, Michigan, when it petitioned the Court.

Petitioner is a professional medical corporation that provides osteopathic services, with a speciality in oncology (mainly chemotherapy) and hematology. Petitioner's staff consists of physicians, nurses and nursing assistants, laboratory technicians, administrative personnel, and office workers. Petitioner has three offices in the Clinton Township area. At each of these offices, petitioner stores chemotherapy drugs and has the staffing, equipment, and supplies necessary to administer chemotherapy treatments.

Chemotherapy drugs are pharmaceutical drugs which under applicable State (Michigan) law must be prescribed by a doctor and may be sold only by a licensed pharmacist. Petitioner is not a licensed pharmacist, and it is unlawful for petitioner to sell the drugs. Petitioner may use the drugs during the performance of its chemotherapy services.

Chemotherapy drugs come in ready-to-use form or as powders or liquids that require mixing. Petitioner generally maintains about a 2–week supply of chemotherapy drugs, and it regularly purchases chemotherapy drugs from suppliers to insure that it has enough on hand to administer prescribed treatments. Chemotherapy drugs, in an unmixed form, have shelf-lives varying from about 6 months to 1 year.

When an individual first becomes a patient of petitioner, one of petitioner's physicians examines him or her to prescribe necessary treatments, and that physician records the individualized chemotherapy treatment in the patient's file. After the patient is evaluated and the physician prescribes a chemotherapy regime, the patient begins regular, periodic treatments. The patient does not select the type or quantity of drugs used in the treatments; this selection is within the sole discretion of petitioner's professional staff. In accordance with standard oncology practice, patients are not examined by a physician at every chemotherapy treatment but are usually reexamined by a physician every 4 to 6 weeks during the ongoing course of treatments. Any changes in the future course of treatments are documented in the patient's file at that time.

Petitioner's personnel mix and otherwise prepare the chemotherapy drugs that petitioner administers to a patient; the chemotherapy drugs cannot be self-administered. One of petitioner's oncology nurses generally performs the administration, and a physician is always on site to respond to emergencies. The physician is not always in the room during the administration.

Petitioner is a participating provider with Medicare ¹ and several other private insurance carriers. Virtually all of petitioner's patients who receive chemotherapy treatments are covered by Medicare or private insurance, and those patients are billed only for the cost of the treatments to the extent of co-payments, deductibles, and other uncovered charges. For each patient visit, petitioner's staff prepares a physician's statement known as a “charge sheet”, which is the document from which petitioner's billing department generates its bills. The charge sheet specifically lists the type, amount, and cost of chemotherapy and other drugs administered, and the type and cost of all professional services rendered. The charge sheets are specific as to the particulars of chemotherapy treatments so as to comply with the guidelines of Medicare and the private insurance industry. Petitioner submits the charge sheets directly to Medicare or other responsible party, and petitioner bills its patients for the copayments or other charges not covered by insurance.

Medicare and private insurers analyze on an item-by-item basis whether to reimburse the charges shown on the charge sheets. The dollar amount reimbursed for a drug administered to a patient is ascertained by reference to the average wholesale price (AWP) of the units in which the drug is packaged and sold wholesale, which AWP is published annually with quarterly updates. Generally, the reimbursement amount for drugs equals the AWP times the units used, with rounding up to the next whole unit of a drug when billing for administration of a partial unit.

It is common industry practice to charge for all medical services provided even when the health care provider anticipates it will not be paid in full for all charges. The standard charge nationally for chemotherapy drugs is 1.5 times the AWP, and petitioner bills its patients for the drugs at this rate with the expectation that the patient will pay the excess over the amount reimbursed. With all reimbursement payments from Medicare or private insurers, petitioner receives an “Explanation of Benefits” that details the amounts allowed and disallowed as to each specific charge, and the amounts for each charge which are due from secondary insurance and/or the patient.

Petitioner has always used the cash method for purposes of both financial and tax accounting, and it has never maintained an inventory of any of the items used in its practice. Petitioner expenses as supplies the cost of all chemotherapy drugs purchased during the year; the actual cost of chemotherapy drugs which it had on hand at the end of 1995 was $31,887. Petitioner deducted on its 1995 tax return $772,522 in “medical supplies” for the actual cost of the chemotherapy drugs and $66,305 in “laboratory supplies” for the actual cost of miscellaneous nonpharmaceutical items. Petitioner reported on its 1995 tax return $2,938,726 in gross receipts and no cost of goods sold.

Respondent determined that petitioner had to inventory its chemotherapy drugs, and, thus, that petitioner's use of the cash method did not clearly reflect its income. Respondent changed petitioner's method of accounting to a hybrid method, which hybrid method accounted for the chemotherapy drugs on an accrual method and the balance of petitioner's business on the cash method. Respondent's change to the hybrid method increased petitioner's income by: (1) $31,887, the actual cost of the chemotherapy drugs on hand at the end of 1995, and (2) $148,557, the value of petitioner's accounts receivable relating to chemotherapy drugs conveyed to patients as of the end of 1995.

Discussion

We decide for the first time whether the furnishing of pharmaceuticals by a medical treatment facility as an integral, indispensable, and inseparable part of the rendering of medical services is the sale of “merchandise” for purposes of section 1.471–1, Income Tax Regs. In Hospital Corp. of Am. v. Commissioner, 107 T.C. 116 (1996) ( HCA ), we held that medical supplies and pharmaceuticals used by hospitals are so vital to the furnishing of medical services that income earned therefrom constitutes income earned from the performance of services for purposes of the nonaccrual-experience method of section 448(d)(5). In HCA, we explicitly reserved for another day the question of whether those supplies and pharmaceuticals were merchandise that had to be inventoried under section 1.471–1, Income Tax Regs. See id. at 143–144 n. 18. That day is here in the factual setting of a physician's outpatient chemotherapy treatment facility.

We decide this issue in the context of whether it was an abuse of respondent's discretion to exercise his authority under section 446 and require petitioner to change from the cash method to a hybrid method.² Presented is the question of whether petitioner should be required to keep inventories for tax purposes under section 471. Respondent determined that petitioner's chemotherapy drugs were merchandise that was an income-producing factor, that petitioner therefore was required to inventory the drugs, and that petitioner was required to use an accrual method to account for this inventory in order to reflect its income clearly. Petitioner asserts that it is not a merchandising business but a provider of...