Physician Practice Taxes: Collections Not Charges, the Credit Balances, the Ancillary Services, and the Stark Rules That Shape the Compensation

A physician practice is a revenue cycle with a clinic attached, and the return follows the collections. Collections, not charges: a practice's charges (its fee schedule) are not its income; its income is what it collects — the payer's allowed amount (the contracted rate for commercial plans, the fee schedule for Medicare, the state's rate for Medicaid) and the patient's share (copays, coinsurance, and deductibles), with the contractual adjustment (the difference between the charge and the allowed amount) never income and never a deduction (the dental deductions guide's rule); under the cash method (most practices), income is the collections as they arrive — the payer's remittance weeks after the claim, the patient's balance after the explanation of benefits — so the practice's accounts receivable at year-end are next year's income, and the practice management system's reports (charges, adjustments, collections, and the aging by payer) are the books' foundation. The credit balances — a liability, not income: overpayments (a payer that paid twice, a patient who paid a deductible the insurer later covered, a secondary payer's duplicate payment) create credit balances on patient accounts — money the practice owes back; for tax purposes, a payment the practice receives believing it's entitled to it is income when received under the claim-of-right doctrine, with a deduction when refunded (section 1341's relief if the repayment exceeds US$3,000); an amount the practice knows at receipt it must return — a duplicate payment, an overpayment already identified — isn't held under a claim of right and is a liability, not income; and for compliance, Medicare and Medicaid overpayments must be reported and returned within sixty days of identification (the Affordable Care Act's overpayment rule — since January 1, 2025, an overpayment is identified when the practice knows of it or acts in reckless disregard or deliberate ignorance of it, and the sixty days can be suspended for up to 180 days while a timely, good-faith investigation quantifies related overpayments; an unreturned overpayment becomes a False Claims Act exposure); the practice's credit balance report is reviewed monthly and refunds made. The ancillary services — revenue the rules constrain: in-office imaging (X-ray, ultrasound, MRI, CT), clinical laboratory, infusion, physical therapy, and durable medical equipment — revenue lines with their own equipment, staff, and supplies — are subject to the federal physician self-referral law (the Stark law: a physician may not refer Medicare patients for "designated health services" to an entity with which the physician has a financial relationship unless an exception applies — the in-office ancillary services exception is the one that allows a group practice to provide imaging and lab to its own patients, with conditions on the location, the billing, and the supervision) and the anti-kickback statute (no remuneration for referrals of federal program business); the tax treatment is ordinary (revenue when collected; the equipment on the depreciation schedule — an MRI is five-year property (asset class 57.0, professional services) expensed under section 179 or bonus; the supplies and reagents as costs; the technologists on payroll), but the structure (who owns the imaging, where it's located, how the physicians are compensated from it) is a compliance decision first. The Stark rules and compensation: a group practice's physicians may be paid a share of the group's profits from designated health services only in ways that don't directly reflect the volume or value of each physician's referrals (the group practice rules — since 2022, a profit share must pool the profits from all of the group's designated health services, or all of those of a component of at least five physicians, rather than one service line, and may be divided per capita, in proportion to the group's revenue from services that aren't designated health services, or by another method that doesn't directly reflect referrals; productivity bonuses rest on the physician's personally performed services); a group that pays each physician a percentage of the imaging revenue from their own referrals violates the law; the compensation plan is reviewed by healthcare counsel, and the tax consequence follows the plan (the physicians' W-2 compensation or partnership distributions). Staff and the practice's costs: the medical assistants, nurses, front-desk and billing staff, and the practice manager on payroll (the carpet cleaning classification guide — clinical staff on the practice's schedule are employees), the associate physicians and advanced practice providers (employees — the practice's schedule and patients; a physician covering shifts as their own business — the locum tenens physician placed by an agency — is the agency's or a contractor), the EHR and practice management system (a large subscription), the clearinghouse and billing service (a percentage of collections — its own line), the medical supplies and vaccines (the vaccine inventory — expensive, counted at year-end, and a cost when administered), the malpractice (per physician — deductible; tail coverage when a physician leaves — deductible when paid), the licensing (state licenses, DEA registrations, board certifications and maintenance — deductible), the credentialing with each payer, the HIPAA program (the HHS rules), the OSHA program, the CLIA certificate for in-office lab testing, the medical waste, and the rent (the medical office build-out — qualified improvement property in a leased space — the leasehold improvements guide; an owned building in a separate real estate LLC — the auto repair entity guide's structure — subject to the Stark rules' rental exception if physicians lease to the practice: fair market value, a written lease, not tied to referrals). The value-based payments: the incentive payments and shared savings from Medicare's quality programs, the accountable care organization's distributions, and the commercial payers' value-based bonuses — income when received, often a year after the performance period; the negative adjustments reduce the next year's payments. Entity and the specified service question: medicine is in the health field — the QBI deduction phases out above the taxable-income range, and for most practice owners is zero; the retirement plan (a safe-harbor 401(k) with profit sharing and a cash balance plan — the dental entity guide) is the planning instrument (the physician practice entity guide). Sales tax: medical services are exempt; the practice pays sales tax on its supplies and equipment at purchase; retail sales (supplements, skincare in a dermatology practice) are taxable. The bookkeeping: charges, adjustments, and collections by payer; the aging; credit balances and refunds within sixty days; ancillary revenue by service with its equipment and staff; the compensation plan's allocation documented; payroll; malpractice with tails; licensing and credentialing; value-based payments by program; the build-out and equipment. The errors: charges booked as revenue (or contractual adjustments deducted); credit balances held past sixty days (a compliance exposure); an ancillary profit allocation tied to referrals; the vaccine inventory uncounted; the tail premium missed in a physician's departure year; and the physician-owned building leased at a rent the Stark exception wouldn't support.

Key takeaways

• Collections are the income, not charges — contractual adjustments are never income or deductions; year-end receivables are next year's income under the cash method.
• Credit balances are money owed back — Medicare and Medicaid overpayments must be refunded within sixty days of identification; refunds are deductions (or reductions) when paid.
• Ancillary services (imaging, lab, infusion, therapy) are ordinary revenue with ordinary equipment treatment — structured first under the Stark law's in-office ancillary exception and the anti-kickback statute.
• Ancillary profits can't be allocated to physicians by their own referrals — per capita, personal productivity, or another referral-neutral method, reviewed by healthcare counsel.
• Malpractice (with tails at departure), licensing, credentialing, HIPAA, OSHA, CLIA, and the EHR are the practice's mandatory costs; a physician-owned building is leased at fair market value under the Stark rental exception.
• Medicine is a specified service trade — the QBI deduction is zero above the range; the retirement plan is the instrument.

The physician practice's deduction file

Charges, adjustments, collections by payer; aging. Credit balance report monthly; refunds within sixty days. Ancillary revenue by service; equipment (MRI, CT, lab analyzers); technologists; supplies; the Stark exception documented. Compensation plan with referral-neutral ancillary allocation (counsel's review). Payroll: clinical staff, associates, advanced practice providers. EHR, clearinghouse, billing service. Vaccine inventory count. Malpractice per physician; tails. Licenses, DEA, board certification, credentialing. HIPAA, OSHA, CLIA, medical waste. Value-based payments. Rent or real estate LLC at fair market value. The collections line and the credit balance report are the two the auditors — tax and compliance — read first.

Worked example

A six-physician internal medicine group collects US$6.8 million (US$11.2 million of charges; US$4.4 million of contractual adjustments never touch the return; US$780,000 of receivables at year-end — next year's income). Ancillaries: in-office X-ray, ultrasound, a CLIA-certified lab, and an infusion suite — US$1.4 million of collections under the in-office ancillary services exception (same building, the group's own supervision and billing), with a new ultrasound unit (US$85,000, section 179) and the lab analyzers on a reagent-rental agreement (no asset); the ancillary profits allocated to the physicians per capita (not by referrals), per the compensation plan counsel reviewed. Credit balances: US$62,000 identified during the year — refunded within sixty days (Medicare's portion within the sixty-day rule), each refund a reduction of income when paid. Staff: 34 on payroll; two nurse practitioners employed. Malpractice for six physicians and two NPs; a departing physician's tail (US$28,000) deducted when paid. Value-based: US$140,000 of shared savings from the group's accountable care organization, paid in October for last year's performance — income when received. The building in the physicians' real estate LLC, leased to the group at a fair market rent supported by an appraisal (the Stark rental exception). Net profit to the physicians is in the millions — a professional LLC taxed as a partnership (the entity guide), the QBI deduction zero, a cash balance plan with US$1.1 million of combined physician contributions. A neighboring practice paid its physicians a share of imaging revenue based on each one's orders — a Stark problem that also rewrote three years of its physicians' W-2s in the settlement.

Official sources

HHS states: “HHS published a final Privacy Rule in December 2000, which was later modified in August 2002. This Rule set national standards for the protection of individually identifiable health information by three types of covered entities: health plans, health care clearinghouses, and health care providers who conduct the standard health care transactions electronically.” — U.S. Department of Health and Human Services, HIPAA for Professionals, https://www.hhs.gov/hipaa/for-professionals/index.html

The IRS states: “The SSTB exception does not apply for taxpayers with taxable income at or below the threshold amount and is phased in for taxpayers with taxable income within the phase-in range. For taxpayers with taxable income above the phase-in range, no deduction is permitted with respect to any SSTB.” — Internal Revenue Service, Section 199A qualified business income deduction FAQs, https://www.irs.gov/newsroom/tax-cuts-and-jobs-act-provision-11011-section-199a-qualified-business-income-deduction-faqs

Practitioner note

A physician practice's return is its revenue cycle: collections rather than charges, contractual adjustments that never exist as income, credit balances that are money owed back within sixty days for Medicare and Medicaid, and ancillary services whose tax treatment is ordinary but whose structure the Stark law and the anti-kickback statute decide first. Our practice files reconcile collections by payer to the practice management system, review the credit balance report monthly, document the ancillary exception and the referral-neutral profit allocation, and lease the physicians' building to the practice at an appraised fair market rent — because the compliance auditor and the tax examiner read the same ledger.

See also: For related guidance, see the medical spa entity guide, with its management company and professional entity; and browse every small business tax guide, by situation.

Next step

Fairlight Accounting is a cross-border accounting and tax practice with a U.S. Tax Desk and a Canadian Tax Desk. Our U.S. Tax Desk handles physician practice returns — collections-based revenue and contractual adjustment treatment, credit balance and overpayment refund compliance, ancillary service accounting under the Stark in-office exception, referral-neutral compensation allocation, malpractice tail treatment, credentialing and licensing costs, value-based payment timing, and fair-market-value real estate leases. See pricing or book a call.