23rd Annual Health Sciences Tax ConferenceTax accounting methods update: let’s not forget about the basics

December 10, 2013

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Disclaimer

Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

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Disclaimer

EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. For more information about our organization, please visit ey.com.This presentation is © 2013 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party.Views expressed in this presentation are not necessarily those of Ernst & Young LLP.

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Presenters

Jack DonovanErnst & Young LLP1101 New York Ave., NWWashington, DC+1 202 327 8054jack.donovan@ey.com

Alison JonesErnst & Young LLP1101 New York Ave., NW Washington, DC+1 202 327 6684alison.jones@ey.com

Dan PenrithErnst & Young LLP1101 New York Ave., NW Washington, DC+1 202 327 6606dan.penrith@ey.com

Glen MortensenDirector, Corporate TaxHCA HealthcareNashville, Tennessee

Craig PickardVice President, Corporate TaxationCommunity Health SystemsFranklin, Tennessee

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Agenda

Update: recovery audit contractor (RAC) auditsRefresher — accounting methods and transactions

Taxable transactionsTax-free transactionsCash method vs. accrual method considerations

Transaction cost analysis (TCA) updateOther considerations

Year-end planningDeductibility of fines and penalties

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Update: RAC audits

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RAC audits

RAC: recovery audit contractor.RAC audit: Center for Medicare & Medicaid Services (CMS) employs RACs to conduct post-payment reviews of claims filed with CMS by taxpayers for reimbursement for services previously provided.If RAC determines reimbursement is made in error, letter is sent to taxpayer demanding repayment of all or a portion of previously reimbursed amount.

Appeal process is available to taxpayer.Recoupment by CMS is forced after appeal failure.Taxpayer can still appeal further after recoupment.

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RAC audits

Opportunity: deduction available to taxpayer during taxable year amount is recouped by CMS.Section 461(f) and Treas. Reg. Section 1.461-2 provide that if:

Taxpayer contests a liabilityTaxpayer transfers money or other property to satisfy liabilityContest still exists after time of transferAbsent the fact the liability is contested, a deduction would be allowed during the taxable year of transferDeduction for contested amount allowed in taxable year of transfer

If a refund is received by taxpayer subsequently as a result of success during appeals, amount is includable in gross income in taxable year of receipt.

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RAC audits

Successful in obtaining Internal Revenue Service (IRS) consent for a taxpayer to deduct RAC audit liabilities in the tax year recouped by CMSConsent received with little resistance from IRS

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Refresher — accounting methods and transactions

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Taxable transactions

Taxable stock acquisition Generally, accounting methods carry over. Generally, tax basis in assets/liabilities carries over.

Taxable asset acquisitionGenerally, new accounting methods may be adopted. Generally, acquirer receives a step up in basis to fair market value (FMV) for assets received.

Elections under Section 338 — stock purchases treated as asset acquisitions

Generally, new accounting methods may be adopted for target and acquirer receives step up to FMV in the basis of the assets.

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Tax-free transactions

Entity formation: i.e., via a Section 351 transaction (transfer of property for controlling stock) or Section 721 transaction (transfer of property for partnership interest)

Generally, new entity can adopt accounting methods.Some methods may carry over, i.e., fixed assets.

Section 381 transactions, such as reorganizations under Section 368 or liquidations under Section 332

Additional analysis needed to determine accounting methods implications (see next slide)

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Navigating Section 381(c)(4) and (c)(5)

* Rules apply to both overall methods of accounting and to special methods of accounting. See special rules if Acquiring intends to integrate multiple component trades or businesses.

The chart is a summary of §381 guidance and is not a substitute for a detailed reading and application of the pertinent authorities.

The determination of the methods of accounting depends upon the type of transaction. For example, if forming a

new corporation in a Section 351 transaction, generally the taxpayer must

adopt new methods of accounting. However, dropping assets into an existing corporation in a Section 351 transaction

will generally require the taxpayer to continue to use its established methods

of accounting.

Is the established method (carryover method) permissible?

Step 1: Is the transaction one to which §381(a) applies?

Will Acquiring operate the trades or businesses as separate trades or businesses after the transaction? *

Is the Transferor larger than Acquiring? For general methods: Aggregate adjusted basis of assets

and aggregate gross receipts for 12 months preceding date of transaction must both be larger than Acquiring’s.For Inventory: FMV of inventory of a type of goods.

Use Transferor’s methodunless requesting a

voluntary change in method.

Is Transferor’s method a permissible method of

accounting?

No

No

Yes

Yes

NoYes

Yes

No

Use Acquiring’s method unless requesting a

voluntary change in method.

Yes

No

Must request consent to change to a permissible method of accounting.

Yes No

Must request consent to change to a permissible method of accounting.

Use carryover method unless request voluntary

change in method.

Is Acquiring’s method a permissible method of

accounting?

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Cash method vs. accrual method

Section 448 prohibits the use of the overall cash method in the case of a:

C corporationPartnership which has a C Corporation as a partnerOrTax shelter

Certain exceptions, such as entities with gross receipts of not more than $5,000,000

Aggregation rules must be considered for gross receipts test.

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Cash method vs. accrual method

Common situations in which a cash method taxpayer is required to change its overall method of accounting to an accrual method:

S Corporation status terminates because of C Corporation owner.Stand-alone C Corporation with average annual gross receipts of less than $5m is acquired by the parent of a consolidated group (aggregate gross receipts greater than $5m).

Situations also can arise in which a voluntary cash to accrual method change is beneficial.

Ability to deduct certain incurred but not reported (IBNR) “reserves”Use of the nonaccrual experience method

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TCA update

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Rev. Proc. 2011-29

Safe harbor election70% of the fees are non-facilitative costs30% of the fees are facilitative costs

ApplicationApplies only to “covered transactions”Applies only to the transaction for which the election is made Applies to all the taxpayer’s success-based fees for that transactionElection is irrevocable, made with statement attached to return

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Rev. Proc. 2011-29Open issues

Must still determine whether 70% is deductible business expansion cost or amortizable start-up expenditures under Section 195Does not address:

Recovery, if any, of 30% capitalizedOther types of fees, such as retainers and milestone paymentsWhich party to the transaction is entitled to deduct the fees

Transactions that are not “covered transactions” (multi-step or overlap transactions)

Not a method of accountingNot clear how to treat single success-based fee that includes facilitating financing the transaction

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Rev. Proc. 2011-29Other considerations

Safe harbor applies to all success-based fees incurred by a taxpayer in a transaction (analysis should be done in total to determine best answer).Opportunities

Taxpayers with large success-based fees may want to forgo the election if documentation supports a greater deduction.Identify opportunities to determine treatment of non-success-based fee.Bright line date is still relevant for non-success-based and non-inherently-facilitative costs (e.g., due diligence costs).

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LB&I directives

July 2011 Large Business and International (LB&I) Division directive

Examiners not to challenge 70% or less deductions for pre-Rev. Proc. 2011-29 years

April 2013 LB&I directiveIf a taxpayer:

Elects safe harborHas not deducted more than 70% of any “eligible milestone payment”Is not contesting its liability for the eligible milestone payment

Examiners will not challengeeligible milestone payment.

A non-refundable payment paid for investment banking services, creditable against a success-based fee, payable in the course of a covered transaction upon: (i) the execution of a letter of intent or exclusivity agreement, (ii) board approval or (iii) an event occurring after (i) and (ii)

LB&I directives are non-reliance guidance.

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Non-covered transactions: could be significant TCA opportunity

Types of transactionsAsset salesSpin-offs Initial public offeringsDebt restructuring/refinancingsSupply chain projectsInternal restructuringsSections 351 and 721 transfersRecapitalizationsDivestituresBankruptciesLiquidations/incorporations

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Other considerations

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1. Self-insured IBNR expenditures2. Accounts receivable and payable analysis3. Prepaid expenditures4. Deferral of advance payments of income5. Software expenditures

Year-end planning: top accounting methods opportunities

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1. Section 263A (UNICAP) for self-constructed assets2. Compliance with Tangible Property Regulations (TPR) for

implementation in 2012 tax year3. Compliance and implementation with TPR for 2013 or

2014 tax year4. Implementation of method changes after Section 381(a)

transaction5. Retroactive 2012 tax act provisions6. Accounting method changes for taxpayers under IRS

exam7. Cost segregation/fixed asset study8. “Reverse” accounting methods planning

Year-end planning: top compliance method opportunities

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Fines and penalties: deductible?

Generally, Section 162(f) provides, “no deduction shall be allowed … for any fine or similar penalty paid to a government for the violation of any law.”This includes civil penalties when the purpose for such penalties imposed is for enforcing the law in question or is for punishment for violation of the law.

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Fines and penalties: deductible?

Upon analysis of the origin and characteristics of the amounts paid, certain amounts may be deductible under Section 162 as an ordinary and necessary business expense. For example:

Amounts paid shown to be compensatory/remedial in nature may be deductible.Legal fees and expenses incurred in defense of prosecution arising from violation of the law may be deductible.For civil penalties, analysis of the statutory purpose of the penalty could result in the amount paid being deductible (i.e., imposed as compensation for damages arising from its violation).

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Questions?