Chemotherapy Drugs Are NOT Merchandise

In Osteopathic Medical Oncology and Hematology, PC v. Commissioner (113 TC No. 26, 11/22/99) physicians scored a major victory over the Internal Revenue Service. Unlike the typical Tax Court memorandum decision heard by a single judge where the issue(s) involve determination of facts, this was a regular decision reviewed by the entire Court involving a determination of law, "i.e., a rule of general application" quoting Judge Halpern’s dissent. All of the facts of this case were stipulated (agreed to in advance) by the parties. The Court was to determine if the supplying of chemotherapy drugs to patients as part of an oncology practice constituted the sale of merchandise requiring inventory and a hybrid accrual method of accounting to be used. This was a "case of first impression" as the Court noted that it was deciding "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.’" (Emphasis added) Of particular significance in the timing of the decision is that the IRS has recently completed a Market Segment Specialization Program audit of physician practices in the Northeast aimed at developing a new audit manual. These inventory questions were a significant issue in the audits of such practices as radiology.

Osteopathic Medical Oncology and Hematology, PC is a Michigan Corporation engaged in oncology and hematology. It always utilized the cash receipts and disbursements method of accounting, deducting all of the disputed chemotherapy drugs in the year of purchase. It did not maintain a formal inventory (in this case, we mean a recorded or documented count) but typically had a two week supply on hand. After an audit, the IRS determined that the drugs should be inventoried and, further, that the revenues associated with the sale of the drugs should be recorded on the accrual method. The remaining income from medical services could be accounted for using the cash method, thus the hybrid nature of the accounting method under the audit result. The combination of these two factors – inventory and receivables – resulted in an increase in taxable income of approximately $180,000.

The Court (Judge Laro wrote the majority opinion) focused its legal analysis on the definition of "merchandise." Merchandise "is an item acquired and held for sale." The Court noted that under Michigan law, only a pharmacist could legally sell drugs and Osteopathic was not licensed as a pharmacist. Further, the Court noted that despite the fact that Osteopathic followed prescribed Medicare and other payor rules in billing for the chemotherapy drugs separately, this did not compel the conclusion that the drugs were being sold independent of the medical service. The reimbursement received for the drugs from payors was generally the Average Wholesale Price and therefore reflected little or no profit on the purported "sale." The Court even noted that Medicare does not cover (outpatient) prescription drugs that can be self-administered and cited the definition of medical and health services from the Medicare statute.

The Court also focused on the definition of "supplies" to contrast it with "merchandise." Citing the regulations under section 162, the Court noted "If a taxpayer carries incidental materials or supplies on hand for which no record of consumption is kept or of which physical inventories at the beginning and end of the year are not taken, it will be permissible for the taxpayer to include in his expenses and to deduct from gross income the total cost of such supplies and materials as were purchased during the taxable year." The Court determined that the IRS could require Osteopathic to use the proposed hybrid method if "1) Petitioner (the taxpayer) produced, purchased or sold merchandise, and 2) petitioner’s production, purchase or sale of merchandise was an income-producing factor."

The Court determined that the taxpayer did not produce, purchase or sell merchandise and therefore did not have to make the second determination. "Petitioner’s business is a quintessential service business. … Although it furnishes chemotherapy drugs to its patients as part of its service, a person cannot obtain the drugs but for the chemotherapy treatments … Where, as here, the service provider dispenses the drugs as an indispensable and inseparable part of the rendering of services, the service provider is not selling ‘merchandise.’" (Emphasis added) The Court went on to note that "The mere fact that the chemotherapy drugs are expensive is insufficient to transmute the transaction from the sale of a service to the sale of merchandise and a service."

The IRS has broad authority to require a taxpayer to use a method of accounting that "clearly reflects income" as specified in the regulations under section 446 (generally) and 471 (as to inventory). The IRS cannot compel a taxpayer to change its method however if the existing method clearly reflects income, even if the IRS method would also clearly reflect income. The Court had to find that the method used by the taxpayer (already) clearly reflected income in order to find that the one proposed by the IRS constituted an abuse of discretion. In so finding, in a decision reviewed by the entire Tax Court, a precedent of major import has been established that will alter the outcome of future conflicts between physicians and the IRS.

The emphasized quote above is perhaps the key to understanding the Court’s decision and applying it to other types of practices: "Where, as here, the service provider dispenses the drugs as an indispensable and inseparable part of the rendering of services, the service provider is not selling "merchandise." Practitioners should focus their analysis of individual clients in various medical specialties on this criterion, without losing site of the broad purview of section 446. The examples which follow attempt to answer the inventory question for different practices where significant amounts are expended on supplies.

Clearly, radiologists are not selling film, contrast (for MR and CT), developer or any of a host of other supplies consumed in the process of providing radiological services to their patients. However, global billing for radiology services consists of the professional component of interpreting the film and the technical component for the provision of equipment and supplies necessary to make the film. Clearly, the interpretation of the film covered by the professional component is a pure service. Less clear is whether the generation of the film paid for via the technical component is a pure service. Unlike the provision of chemotherapy drugs for which no separate payment beyond the average wholesale price is typically made, there is a distinct revenue stream associated with the technical component. Further, and likely more significant, it is possible for the actual filming to be provided by one taxable entity and the interpretation to be done by another.

Another aspect of the Decision that is relevant to the determination is the question of "if the taxpayer produced, purchased or sold merchandise." Arguably, the generation of a film is a production activity, where the delivery of chemotherapy is not. If this threshold test is met, the second question "is the production, purchase or sale of merchandise was an income-producing factor" is easily answered yes based upon the technical component revenue stream. Nonetheless, if the film is an "indispensable and inseparable part of the rendering of services" the taxpayer still has an argument that the accrual method is not required. It is possible that an integrated radiology practice which bills the global fee may be treated differently than a radiology facility which bills only the technical component.

An optometry (or ophthalmology) practice clearly is selling merchandise in the form of eyeglasses or contact lenses and it would seem indisputable that inventory and accrual method would be required with respect to this activity. As is the case with radiology, there is a separate stream of revenue associated with the sale of eyeglasses, distinct from that associated with prescribing them. The possibility is raised that such a practice may use a hybrid method of accounting, reporting the service portion on the cash method and the merchandise portion on the accrual method.

The taxpayer would appear to have a better argument for the cash method after Osteopathic. Patients cannot obtain silver or porcelain fillings nor self-administer them, and the filling material is clearly an inseparable part of the service. Practices that do prosthetic work generally are ordering the prosthesis from a lab and not keeping them on hand. However, here again we have risk because the dentist is a re-seller of the prosthesis, for which a separate charge would typically be made. Perhaps this indicates an accrual method, although it would have little if any impact on taxable income in the absence of inventory and receivables (and as such lessen the prospect for a general attack under section 446’s "clear reflection" standard). The language of the decision seems quite strong even in this circumstance however, since the prosthesis is an inseparable part of the service.

If a physician practice owns, for example, a blood chemistry machine and performs its own blood tests, should this be considered the sale of merchandise? The supplies inventory consists of reagents and other items necessary to perform the tests. Automated lab tests do not have a substantial service element associated with them, unlike pathology tests that require interpretation. If the tests are provided only for the practice’s own patients (and in light of licensing requirements, this might be expected to be the case) they would arguably be seen as integral part of the diagnostic component of the medical service.

The issue here would involve breast implants, collagen and similar prosthesis or supplies. Again, since a patient cannot self-administer such things and they are an inseparable part of the service, it seems unlikely that an accrual method could be required. (Author’s note: I once had a sales tax agent unsuccessfully attempt to tax breast implants and collagen being "sold" by a plastic surgeon.) However, those cosmetic practices that sell skin care products need to maintain inventories, and if such sales are other than for cash, they may need to reflect receivables.

Practitioners now have a basis upon which to advise clients as to the risk associated with certain medical activities that include substantial supplies costs. The Osteopathic case offers criteria or guidelines for evaluating the risk of a challenge to the physician’s method of accounting.

• Ideally, no record of consumption or physical inventories of such supplies should be maintained since the regulations at section 162-3 specifically cite this as prerequisite for deducting supplies in the year purchased rather than when consumed.
• The issue is not solely limited to one of inventories under section 471, but also the requirement under section 446 that the accounting method must clearly reflect income. The IRS could exercise its broad authority under 446 without resorting to a requirement that inventories be accounted for, a point made by Judge Halpern in the dissent described below. Beware mismatches in the deduction of supplies expenses and the reporting of the revenue generated in the consumption of the supplies.
• The ability of personal service entities to use the cash method of accounting under section 448 is not a barrier to the IRS requiring the taxpayer to use a method of accounting which clearly reflects income under section 446.

The Court made it clear that it was directly addressing only the issue of a "physician’s outpatient chemotherapy facility" and practitioners should be cautious about drawing broad conclusions about other practices without carefully studying the decision. Judge Halpern’s lengthy dissent (with which Judges Cohen, Whalen and Chiechi joined) indicates that he, at least, will narrowly interpret the majority’s decision when similar cases come before him. He states that the issues presented to the Court by the IRS are very narrow and cautions that "Taxpayers not read too much into that determination." He concludes his dissent by warning, "Taxpayers similarly situated to petitioner should be prepared to demonstrate that the cash method clearly reflects their income or that the hybrid method does not." I echo his admonition.

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