Your 1040

Steer clear of these audit minefields

Managed care may trigger IRS scrutiny, andother tax offenses have cost physicians big bucks. Here are tipsfor staying on safe ground.

By Doreen Mangan, Senior Editor

Years ago, when patients paid doctors directly, the IRS suspectedphysicians of concealing cash. But insurers' checks eventuallyreplaced those payments, and cash became less of an issue. Now,though, with the spread of managed care, the IRS has cottonedon to the fact that doctors are again collecting cash, in theform of copays. The IRS' worry: Physicians may be tempted to pocketthis money and not record it, says Harvey Susnick, a Jericho,NY, CPA. "We've had a few audits where the agent requestedthe daysheet and the appointment list, to make sure the daysheetreflected the dollars deposited," he says.

Another result of managed care has been an increase in thenumber of practice sales. And some doctors who've sold to physicianpractice management groups have had the IRS question the natureof the transaction.

Aside from those managed care issues, our recent survey ofhundreds of doctors, accountants, and tax attorneys revealed thatmany physicians get audited because they make innocent mistakes,don't consult CPAs, or neglect to follow their tax advisers' recommendations.

The results can be painful, indeed.

Kathleen B. Unger, a San Francisco psychiatrist, recalls theone time the IRS audited her, in 1984. It was winter, and theauditor came down with the flu. "I was so understanding abouthis being incapacitated," she says. "I didn't complainabout the delay, as I was then an entrenched member of the OstrichSchool of Money Management and chairperson of its procrastinationcommittee." A month passed before the audit resumed. Theagent found an underpayment. Unger was assessed interest for themonth the auditor was ill, too, even though she didn't cause thedelay. "Is there any way to make the clock stop ticking insuch cases?" Unger asks.

Unfortunately, no, says CPA Lynn Conover of Red Bank, NJ: "TheIRS is slow, and audits drag on. But regardless of whose faultthe delay is, you can never get the interest abated."

Below are some of the other audit woes we heard about, andthe lessons you can learn from them.

An audit from hell—and its costs

A Cleveland Heights, OH, internist told us of a random 1995audit for the tax year 1992. The IRS was questioning a CME deduction."I'd taken my children with me," she recalls, "andthey'd stayed in my hotel room. But the IRS said the trip waspart pleasure and disallowed a percentage of the deduction forthe room and airline tickets." For that year, the doctorhad to pay $1,500, which included additional tax, a penalty, andinterest. It didn't end there. The agent proceeded to do a gross-receiptsaudit of the doctor's personal income tax return. This meant shehad to account for every deposit to any of her 17 accounts, includinga 401(k), custodial accounts for the children, checking, moneymarket, and mutual funds.

The IRS was looking for unreported income. "I wasn't inthe habit of recording the source of money when I made a depositinto one of those accounts," the doctor says. "Theyincluded tax refund checks, personal loan repayments, rebate checks.And I'd deposited insurance proceeds from several losses on myhome—$12,000 worth, reimbursed in various stages. I frequentlycashed checks for family members by depositing them into my accountand then giving the person cash. All this information had to bereconstructed, along with all the statements.

"The IRS then decided to do a gross-receipts audit for1993 and 1994 as well. When my accountant's fees hit $8,000, Ihad to let him go and try to do it on my own. Not only did I haveto identify where the money for each deposit came from, I hadto prove that it actually came from that source.

"So I had to get copies of the insurance settlement papers;letters from people who had repaid me personal loans or for whomI'd cashed checks; and copies of all bank, checking, home equity,money-market, mutual fund, and 401(k) statements. I even had toget a letter from my 401(k) company from which I'd taken a loan.All deposits are considered income by the IRS until proven otherwise."

Although the doctor ended up owing only $2,000 in back taxes,she paid a tremendous cost in accounting fees. She also had todevote many evenings and weekend hours to the project.

"I now keep all stubs for any money received and carefullydocument any money transfers," she says. "When I notea deposit in my check ledger, I indicate where the money camefrom."

The lesson: "It's easier to record this information asyou go along than to have to collect it all for an audit,"says John V. O'Connor Jr., an Albany, NY, CPA. If you or youraccountant prepare all the backup material before you meet withthe auditor, you've a good chance of getting a quick end to themisery. "I usually give the auditor a few work papers andbackup," O'Connor says. "After he studies them for awhile, I might say, 'You probably get a sense that things arein order.' Often the response is Yes. And pretty soon the auditis over."

The whiplash from a stash of cash

Al Zdenek, a Flemington, NJ, CPA and financial planner, tellsof a doctor client who believed in keeping a lot of cash at theready in case of emergencies. He reported all his income and paidall his taxes. But he regularly stashed extra bucks in his safedeposit box. Over many years, he accumulated $25,000. Then oneday, he decided to buy a $25,000 Pontiac, using cash from hissafe deposit box. An audit at the car dealership led the IRS tothis doctor, who then had to prove that he'd paid tax on all thatmoney.

"It was a real headache," Zdenek says. "He hadto account for all his income, from both his practice and investments,going back three years, and show how he'd spent or saved it. Ittook months." In the end, the doctor had to pay a few hundredbucks to the IRS—and a fee of about $5,000 to Zdenek.

The lesson: You can be audited through no fault of your own.If the car dealer hadn't been audited, this doctor wouldn't havebeen, either. So even if you've followed every IRS rule to theletter, you'd better be ready to prove it. Like the doctor inthe previous case, Zdenek's client would have paid a much lowerCPA fee if he'd been better
prepared.

Car deductions belong to the car owner

Several years ago, the IRS audited FP Robert S. Maurer's Avenel,NJ, practice after he, his partner, and a physician employee deductedautomobile depreciation and other costs of cars that they ownedin their own names.

"If we'd owned them in the practice's name, the insurancepremiums would have been higher," Maurer says. "I triedto explain to the IRS that because we bought insurance privately,we were reducing our writeoff on the tax return. But the IRS wouldn'tbuy it. They said that the corporation couldn't pay expenses ofprivately owned vehicles."

If the corporation had owned the cars and deducted the expenses,that would have been fine. If the individuals had owned the carsand deducted the expenses, that would have been fine, too. However,the IRS disallowed the deductions for the employee-doctor becausehe was a nonowner of the practice.

"Luckily, it didn't cost us anything, because we refiledthe tax statement, and we had some retroactive credits that offsetthe taxes owed," Maurer says.

The lesson: Tell your accountant everything. Although Maurer'sCPA had prepared the tax return, he was unaware that the practicedidn't own the cars.

This is a frequent occurrence, says CPA Lynn Conover. "Wemay see car payments going through the practice, but we don'tnecessarily know whether the practice actually owns the car,"she says.

Doctors also err in the allocation of expenses, regardlessof who owns their cars. "Even if the practice owns the car,you may only deduct expenses that reflect the business use,"Unger says. "If your only business use is to drive from youroffice to the hospital and back, the deduction could be as littleas one-third or one-fourth of your depreciation and costs."

Sidestepping the PPM pitfall

Five years ago, internist Gary L. Parks of Pueblo, CO, andhis four partners sold their practice to PhyCor. Each receivedmore than $200,000. After three years, the doctors were unhappywith their new relationship and left the PPM. During their tenurethere, however, they had the misfortune to be audited, throughno fault of their own. The 25-doctor group Parks and his partnerjoined under the PhyCor umbrella had been audited the previousyear. The auditors returned the next year, and upon going throughthe books and documents, questioned the contract Parks and hispartners had signed.

The partners were even more unhappy when the IRS claimed thatthe proceeds of their practice sale constituted ordinary income,not capital gains from selling a business. The tax agency assessedeach doctor additional taxes of $25,000 to $35,000 for 1994.

Parks' attorney and accountant felt that the profit shouldbe termed capital gains, especially since the contract specificallystated that Phycor bought the group's name and goodwill. "Thatwas a business transaction," Parks says. One of the problemswith the audit, Parks recalls, was that "the agent wasn'tvery bright; our attorney had to explain things to her."The issue was finally resolved in the doctors' favor, but it tooktwo years and cost each of them more than $7,500 in attorneys'fees.

The lesson: If you sell your practice to a hospital, PPM, orother entity, be sure the contract specifically lists each tangibleand intangible asset and its value. The value of each should addup to the purchase price. "It should be a reasonable allocationamong equipment, goodwill, name, and other assets," saysO'Connor. If there's ambiguity, the IRS will consider part orall of the purchase proceeds as ordinary income and tax you accordingly,instead of applying the long-term capital gains tax of 20 percent.

No coffee, no CPA, no mistake

If you've carefully kept all your records and have nothingto hide, you needn't fear the IRS, says FP Charles Davant IIIof Blowing Rock, NC. He reports the following:

"We panicked once, some years back, when the IRS cameto audit us. Our accountant told us not to worry, and he spentseveral days in our office spoon-feeding the IRS auditor. Whenthe dust settled, we owed the IRS $2,000—and got an itemizedbill from the accountant for $4,000.

"When the IRS came for a follow-up audit the next year,we put the agent in a room by himself with our books and not somuch as a cup of coffee. We didn't owe a dime and saved a lotof coffee."

The lesson: Don't create your own audit minefield when theIRS doesn't present you with one. If the information the agentwants is routine, just hand it over and keep your accountant outof it. If you don't have a problem, your accountant isn't likelyto save you a lot up front, Davant says. "On the contrary,you could wind up paying more unnecessarily—to the accountant."

. Steer clear of these audit minefields.

Medical Economics

2000;3:222.