In Letter Ruling 201451009, the IRS concluded that two professional corporations (PCs) could file a consolidated return with another corporation, even though licensed professionals, not one of the members of the consolidated return group, were the actual legal owners of these PCs' stock, as required by state law.
Defining Affiliated Groups
Sec. 1501 provides that an affiliated group of corporations is permitted to file a consolidated federal corporate income tax return. Sec. 1504 defines the term "affiliated group." With certain exceptions not relevant here, an affiliated group consists of one or more chains of includible corporations if the common parent directly owns the requisite percentage of stock of at least one other corporation, and if stock in each other corporation (other than the common parent) meeting the requisite percentage is owned by other members of the group. The requisite stock ownership percentage is at least 80% of the total voting power and at least 80% of the total value of the stock of the includible corporation.
While these requirements would appear to be contrary to the conclusion reached by the IRS in the letter ruling, specific arrangements in place between the owners of the PCs and the deemed parent corporation or subsidiaries within the consolidated return group established one of the corporations in the group as the beneficial owner of the PC, rather than the licensed professionals charged with holding legal title to the PC's stock.
State Law Corporate Practice of Medicine
Many states have enacted laws for medical groups, commonly referred to as corporate practice of medicine or CPOM laws. These rules generally require a medical practice to be owned by the doctors providing medical services to patients, or by doctors supervising other doctors providing medical services to patients. The purpose of this requirement is to ensure that the ultimate legal responsibility for any risk of loss resulting from medical malpractice falls on the doctors directly or indirectly responsible for the medical treatment provided to patients.
Since these laws were established at the state level, each state has created different laws that regulate the extent to which direct or indirect owners of a medical practice must be the licensed professionals responsible for the quality of medical services provided to patients.
Some states strictly prohibit nonlicensed professionals from direct or indirect ownership of PCs. This presents a challenge to medical professionals who would like to grow their practice through the use of funding from private equity, venture capitalists, or similar sources that are generally only willing to invest in the medical practice in exchange for an ownership interest.
A specialized ownership structure has traditionally been used to meet the demands of a potential private-equity investor while avoiding violations of state CPOM rules. The medical practice is generally bifurcated between two business lines: (1) medical services provided to patients by doctors, nurses, and other licensed professionals, and (2) back-office functions needed to run the practice, including, but not limited to, medical billing, accounts receivable tracking, general accounting functions, and booking daily medical appointments.
Any and all functions directly related to providing medical services to patients are maintained within the PC. Ownership of the PC is held by a licensed physician involved in the medical practice in accordance with state CPOM rules. Additional agreements are executed whereby the licensed physician owner is prohibited from realizing the full benefits of owning the PC. The ownership rights that are often forfeited by the PC owner may include:
- The right to dividends, liquidating distributions, or return of capital;
- The right to sell or transfer ownership of the PC's stock; and
- The authority to cause the PC to liquidate or dissolve.
The benefit of the above privileges is transferred to a separate entity that provides all back-office functions related to managing the medical practice, referred to as a management service organization (MSO).
Management services agreements (MSAs) are drafted between the PC and the MSO, requiring the PC to pay a fee for management services. This fee can be structured as a fixed dollar amount or a formulaic calculation, provided the option chosen meets the criteria under Sec. 482 as an arm's-length transfer price. The fee charged usually results in a significant amount of the business profits being transferred to the MSO after doctor compensation, with minimal value remaining within the PC. Since the net profits generally inure to the benefit of the management company, private equity can then invest in the MSO directly without restrictions, and it is that entity that retains the value of the business, thus indirectly avoiding the state law CPOM restrictions.
Over the years, several letter rulings, field service advice, and other guidance have suggested that stock that is beneficially or equitably owned is counted under the 80% ownership requirement in Sec. 1504. Thus, a parent could count stock as owned even though legal title to the subsidiary was transferred to a nominee to qualify the nominee as a director of the subsidiary. The rulings that generally support consolidated return treatment involve situations where a nominee was at all times legally obligated to hold and deal with the rights afforded by the ownership of the respective shares of stock according to the parent's orders.
PCs May Use Cash-Basis Method of Accounting
Sec. 448 identifies a class of taxpayers that are not permitted to use the cash-basis method of accounting for income tax reporting purposes. Generally, the statute prohibits the cash method for C corporations, tax shelters, or partnerships with a corporate partner. An exception permits the use of the cash-basis method by a corporation that is a qualified personal service corporation (PSC) under Sec. 448(d)(2). That provision defines a "qualified personal service corporation" as any corporation:
- substantially all of the activities of which involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and
- substantially all of the stock of which (by value)
is held directly (or indirectly through 1 or more
partnerships, S corporations, or qualified personal
service corporations . . .) by:
- employees performing services for the corporation in connection with the activities involving a field referred to [above],
- retired employees who had performed such services for the corporation,
- the estate of any individual described in [items] (i) or (ii), or
- any other person who acquired the stock by reason of the death of an individual described in [items] (i) or (ii) (but only for the 2-year period beginning on the date of the death of that individual).
As a result of the significant amount of medical billing incurred ahead of collections, a PSC or PC can greatly benefit from using the cash method by paying tax on income as cash is collected in lieu of paying tax on income when invoicing patients, health insurance providers, or Medicare/Medicaid.
Letter Ruling 201451009
On the facts of the ruling, Parent, a common parent of an affiliated group of corporations that files a consolidated federal income tax return on a calendar-year basis (the Parent Group) owned, through disregarded entities, a wholly owned subsidiary (Sub), and member of the Parent Group.
PC1 is a State B professional corporation, and PC2 is a State C professional corporation. Under each respective state law, the shares of the PCs engaged in the profession generally may only be issued to, held by, or transferred to qualified professionals (shareholders).
The PCs conduct the various aspects of their medical profession businesses under state law; however, under the terms of support services agreements between Sub and the PCs, Sub performs all the administrative and support services, including financial reporting, billing, and information systems support, on behalf of the PCs in exchange for a fee. Sub also manages the PCs, and those management operations are tailored so that they do not constitute engaging in the medical profession.
Shareholder and Sub are also parties to a director agreement, whereby Shareholder serves as professional director for the PCs, and oversees and coordinates Sub's business objectives for the PCs. Sub has the right to terminate the director agreement without cause upon notice to the Shareholder. The termination of the director agreement is a transfer event under each of the stock transfer restriction agreements.
Shareholder paid only a nominal amount to acquire and hold legal title to all of the issued and outstanding shares of the PCs. However, each party (Sub, Shareholder, and the PCs) entered into stock transfer restriction agreements for the PCs and Sub. Also, under the bylaws of each PC, the shares of each PC are certificated, and the share certificates are required to be endorsed with a legend, in bold print, noting (among other provisions) that the shares of stock represented by the certificate are subject to the stock transfer restriction agreements. The stock certificates for the issued and outstanding shares of the PCs' stock are issued in the name of the shareholder and bear the required legends.
The bylaws of each of the PCs prohibit the transfer of stock in the respective PC, other than in accordance with the relevant stock transfer restriction agreement, and provide that any person who transfers, holds, or purports to exercise any rights or privileges with respect to any shares of stock in the respective PC in violation of the rights, restrictions, or provisions of the bylaws shall not have the right to vote, receive dividends, or enjoy or exercise any right or privilege as a holder of shares of stock in the PC.
The stock transfer restriction agreements prohibit the shareholder from transferring or disposing of any shares of stock in the respective PCs, except as provided in the stock transfer restriction agreements. The stock transfer restriction agreements also prohibit the shareholder from having a PC make a dividend or other distribution on its stock or issue additional equity interests or rights to acquire additional equity interests, and require the shareholder to take all steps necessary to prevent the PCs from taking any such action. Furthermore, the shareholders are not permitted to consent to a liquidation or dissolution of a PC without Sub's prior consent.
The stock transfer restriction agreements mandate that upon the occurrence of certain events (each a transfer event), the shareholder must transfer, or will be deemed to transfer, all of the shares of the relevant PC to a person or entity identified by Sub (the designated transferee). Any designated transferee will be a professional or entity permitted to directly hold the stock under relevant state law at the time.
A transfer event for a PC includes, but is not limited to, the transfer or attempt to transfer any shares of stock in the PC to a person other than a designated transferee as well as other events that suggest beneficial ownership resides with the Sub.
Based on the facts and information submitted, the IRS ruled that both PCs should be treated as members of the affiliated group (within the meaning of Sec. 1504(a)(1)) of which Parent is the common parent, and they would be permitted to join in the filing of a consolidated federal income tax return with the Parent Group. To receive a favorable ruling from the IRS, Parent represented that (1) the PCs had never declared or paid any dividends, nor made other distributions, to any shareholder; (2) the PCs did not intend to declare or pay any dividends, or make any other distributions, to any shareholder, except for distributions to Sub or other members of the Parent Group; (3) a designated transferee of shares under a stock transfer restriction agreement would be required to execute a new stock transfer restriction agreement having terms substantially similar to the existing stock transfer restriction agreement; (4) the legal arrangements created by the stock transfer restriction agreements were valid and legally enforceable under applicable law; and (5) applicable law did not prohibit the beneficial ownership of stock in the PCs.
As part of the 2014–2015 Priority Guidance Plan of the IRS and Treasury Department, the IRS has listed several consolidated return areas where it wishes to issue further guidance, and practitioners are hopeful that issues of beneficial ownership will be incorporated into some of this new guidance. IRS representatives have informally stated that the Service will take a closer look at who beneficially owns the stock of medical practices when making these determinations.
The ability to include PCs in a consolidated return filing with an affiliated group provides a tremendous benefit because a consolidated return filing allows for the offsetting of income and loss between profitable and unprofitable entities within the beneficially owned groups and minimizes the pressure to continuously update intergroup transfer-pricing arrangements from a federal income tax perspective. However, currently, if a PC takes the position that the criteria of Sec. 1504 are met, permitting a consolidated federal income tax return filing with an affiliated group, the PC no longer meets the definition of a "qualified personal service corporation" under Sec. 448 because the stock of the PC is considered to be owned by a corporation in the affiliated group, not the PC shareholders who legally own the PC. The change in status will require the PC to report on the accrual-basis method of accounting, which may trigger a material positive Sec. 481(a) adjustment, since unrealized receivables are usually in excess of accrued expenses.
Practitioners are hopeful that the IRS will release further guidance in the near future to prevent the tax return filing uncertainty that currently exists. While a consolidated return filing seems to be the correct result given the circumstances presented in Letter Ruling 201451009, the IRS should issue a firm set of guidelines, especially considering the increasing prevalence of these beneficial ownership arrangements.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Bethesda, Md.
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