Many independent professional medical and dental practices are incorporated under state law as professional corporations (PCs). Generally, these state laws require that PCs issue shares only to individuals who are duly licensed or otherwise legally authorized to render the same type of professional services as those for which the PC was organized. Thus, entities other than individuals (corporations, partnerships, etc.) are not authorized by law to own such stock.
Frequently, a licensed individual practitioner (employee) legally owning PC stock enters into a contractual agreement with a management company engaged in the business of providing administrative, financial, marketing and other non-healthcare personnel, facilities and equipment to independent professional medical practices. Typically, these agreements severely restrict the employee’s rights as a stockholder. For example, the agreement may require the employee to vote the stock of the PC and elect the board of directors in accordance with the management company’s recommendation. In addition, the employee may not be entitled to any dividends or capital appreciation on the PC’s stock, nor be liable if it declines in value. Further, the agreement may provide the management company with the option to purchase the employee’s PC stock (at any time) through another licensed individual under its employment for the initial nominal capital originally contributed by the employee for the PC stock.
If the management company holding all these important rights is itself a corporation that joins in a consolidated Federal income tax return, does the PC thus become a member of that group?
Code and Case Law
Sec. 1504 provides two general requirements for filing a consolidated return. First, each corporation seeking to file must be classified as an “includible” corporation as defined by exclusion under Sec. 1504(b). A PC is not among the per se nonincludible corporations listed in Sec. 1504(b), so the analysis moves to the second requirement.
To be part of an affiliated group, the stock of each includible corporation must meet certain ownership tests. Sec. 1504(a) defines an affiliated group as one or more chains of includible corporations connected through stock ownership with a common parent that is an includible corporation, but only if said parent directly owns stock meeting the requirements of Sec. 1504(a)(2) in at least one of the other includible corporations, and stock meeting those requirements in each of the includible corporations (except the common parent) is owned directly by one or more of the other includible corporations. For this purpose, stock ownership of any corporation meets the requirements for affiliation if it possesses at least 80% of the total voting power and at least 80% of the total value of such corporation’s stock.
Given the typical state law governing PCs, the management company in the scenario discussed above would not appear to own directly the PC’s stock. However, the IRS and courts have interpreted Sec. 1504(a)’s direct-ownership requirement to mean “beneficial ownership” of stock, not legal ownership. This interpretation of direct ownership recognizes that substance, rather than form, should control. In Macon, Dublin & Savannah Railroad Co., 40 BTA 1266 (1939), the court stated that “direct ownership required by the statute is not merely possession of the naked legal title, but beneficial ownership, which carries with it dominion over the property.” This conclusion followed Corliss v. Bowers, 281 US 376 (1930), in which the Supreme Court stated that “taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed.”
In Miami National Bank, 67 TC 793 (1977), the Tax Court held that a shareholder retained beneficial ownership of stock, even though the stock had been transferred to a subordinated securities account in which the securities broker possessed legal title and could sell it to satisfy creditors’ claims. The shareholder retained significant incidents of ownership, including the right to receive dividends, vote the stock and assign his or her interest in it. While such account was in effect, the shareholder and other holders of such stock agreed to sell over 80% of it to a third-party corporation. Although the shares were not immediately transferred and instead were temporarily maintained in the securities account, the court ruled that, on the date the purchase agreement was signed, the purchasing third party “directly owned” the stock for Sec. 1504(a) purposes, such that the two corporations could file a consolidated return.
Rev. Rul. 84-79: The Service’s view is consistent with the courts’. For example, in Rev. Rul. 84-79, P Corp. wholly owns the stock of subsidiary S Corp., which owns an aircraft it intends to register with the Federal Aviation Administration (FAA). Under FAA regulations, 75% of the voting interest of a corporation wishing to register its aircraft with the FAA must be owned or controlled by U.S. citizens. P did not qualify as a U.S. citizen, so it transferred all its S stock to a revocable voting trust to enable S to register its aircraft with the FAA. Under the agreement, the trustee had all voting powers as to the stock while the trust agreement was in force. However, the trustee could not vote the stock in favor of either a sale of substantially all of S’s assets or its dissolution without P’s authorization. In addition, P retained several rights generally associated with a stockholder, including the right to (1) all dividends (except stock dividends) and (2) remove the trustee at any time without cause and appoint a qualified successor.
In concluding that P directly owned the stock for Sec. 1504(a) purposes, the IRS cited Miami National Bank for the proposition that legal title alone does not constitute direct ownership and further concluded that possession of “everything but legal title” equals direct ownership.
Letter Ruling 9605015: In Letter Ruling 9605015, the Service ruled on facts similar to the medical/dental practice scenario previously discussed. To comply with the relevant provisions of state X’s PC law, Parent acquired several primary-care medical practices using an acquisition strategy in which loans were made to a physician-employee (employee) to set up a PC (New PC), acquire the intangible assets of a targeted medical practice (Old PC), employ the physicians selling the practice and provide medical care. A management services company owned by a subsidiary of Parent (Acquiring) then acquired the tangible assets of Old PC and provided various management and administrative services to New PC.
As part of the transaction, the employee entered into a pledge agreement severely restricting his rights. He was required to vote the New PC stock in accordance with Acquiring’s recommendation and was directed by Acquiring as to New PC’s board of directors and officers. In addition, the employee was not entitled to any dividends or capital appreciation in New PC’s stock. The IRS ruled that the employee’s stock ownership constituted beneficial ownership to Acquiring and, thus, was direct ownership for Sec. 1504(a) purposes.
The Service subsequently changed its conclusion (see Letter Ruling 9752025, retroactively revoking Letter Ruling 9605015). In the later ruling, it provided no explanation as to why its earlier ruling was inappropriate. However, Field Service Advisory (FSA) 199926014 provides useful insight.
FSA 199926014: The FSA addresses whether the pertinent provision of state X bars beneficial ownership of PC stock by a shareholder other than a licensed individual. In its analysis of the legal principles, the Service respects Rev. Rul. 84-79, as well as the findings in the cases discussed above. Nevertheless, the FSA concludes that Parent cannot be considered the beneficial owner of the New PC stock under state law and, thus, cannot be deemed the direct owner of the New PC stock for Sec. 1504(a) purposes. The FSA cites an unnamed provision of state X law (§y) that precludes not only legal, but also beneficial, ownership of a professional corporation by anyone other than a licensed individual. Thus, any attempt by Parent to claim the benefits and assign itself the burdens of owning the New PC stock does not override §y. In addition, §y provides that any transfer of the beneficial ownership of a professional corporation’s stock to someone other than another licensed individual is void. Accordingly, the FSA concludes that Parent cannot be considered the beneficial owner of the New PC stock and, thus, cannot be deemed the direct owner of the New PC stock for Sec. 1504(a) purposes.
In contemplating whether a PC can be included in a consolidated group for Federal income tax purposes, several key issues should be considered. First, any agreements entered into by the employee-shareholder owning the legal title in the stock, with another corporation, should be examined to determine if restrictions have been placed on the shareholder’s rights that may convey beneficial stock ownership to the corporation. Second, the PC law in the state in which it was incorporated should be reviewed to determine whether any language specifically (1) prevents beneficial ownership of a PC by anyone other than a licensed individual or (2) provides that any transfer of beneficial ownership of a PC to someone other than another licensed individual is void. In the case of a medical management company holding agreements with several PCs located in various states, it is quite possible that differences in states’ PC laws could result in some PCs being considered for inclusion in the consolidated group and others being left to file separately.
Given the possibility that a PC may be eligible to join in the filing of a consolidated return, several other interesting collateral questions arise. For example, if PC ownership meets the Sec. 1504(a) affiliated-group requirements, would it be possible to liquidate the PC tax free under Sec. 332 or claim a worthless stock deduction as to its stock, under Sec. 165(g)(3), to obtain ordinary loss treatment? Could the PC’s business be considered under the “affiliated group rule” in assessing whether the active-trade-or-business requirement under Sec. 355(b) has been met? These and other issues could arise from the beneficial ownership of sufficient PC stock.
Annette B. Smith, CPA, Washington National Tax Services PricewaterhouseCoopers LLP, Washington, DC.
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