Income from incidental supplies does not bar a service provider from using the nonaccrual experience method.

• Author: Conjura, Carol

In Hospital Corp. of America, 107 TC No. 8 (1996), the Tax Court made some significant rulings on the use by service providers of the nonaccrual experience method to defer income estimated to be uncollectible. The court ruled that income earned from medical supplies furnished to or used for patients in the taxpayer's hospitals was earned from the performance of services. The court also said the taxpayer must follow the formula in amended Temp. Regs. Sec. 1.448-2T(e)(2) to calculate the uncollectible experience ratio. Service providers should consider the use of the nonaccrual experience method to avoid accruing income from accounts receivable estimated to be uncollectible.

Nonaccrual Experience Method

Sec. 448(d)(5) allows an accrual-basis service provider to avoid accruing income on the portion of its receivables estimated to be uncollectible, based on the provider's experience. The method is not available if the taxpayer charges interest or late payment penalties. Sec. 448(d)(5) was enacted by the Tax Reform Act of 1986, in connection with restrictions placed on the use of the cash method for many corporations. Temp. Regs. Sec. 1.448-2T was issued in June 1987 and amended 10 months later.

The portion of receivables estimated to be uncollectible is generally based on a six-year moving average of the taxpayer's actual bad debts and receivables. The ratio of accounts receivable estimated to be uncollectible is applied to the service provider's outstanding receivable, using either the "separate receivable system" or the "periodic system."

Under the separate receivable system, the ratio is applied to each receivable outstanding at year-end; that portion of the receivable is neither recognized as income nor added to basis. If the amount later collected on the receivable is greater than the basis, the excess is recognized as income in the year of collection. If the ultimate amount collected is less than the basis, the difference between the receivable's basis and the amount collected is a bad debt deduction.

Under the periodic system, the taxpayer establishes a bad-debt reserve account based on the ratio multiplied by the amount of the outstanding receivables. The basis of each receivable is not affected. The reserve account is adjusted periodically for recoveries and write-offs, and the corresponding increase or decrease to the account balance is taken into account in determining taxable income for the period.

If there is a change in the type...