The Tax Court determined a doctor's treatment of an interest in a surgery center as a separate passive activity from his medical practice, after he initially treated it as a nonpassive activity, was reasonable. However, it rejected his deduction of passive activity losses carried forward from the years when he treated the interest as a nonpassive activity, because the correct characterization of the income from the surgery center as passive income in those years would have resulted in the deduction of the passive losses in those years.
Background
Stephen Hardy is a pediatric plastic surgeon who runs his medical practice through a single-member professional limited liability corporation. He performs many surgeries—ones that require only local anesthesia at his office and ones that require general anesthesia or an overnight stay at a local hospital. Initially, Hardy performed surgeries at two local hospitals, allowing his patients to choose which hospital to use after his practice manager estimated how much surgery would cost at each hospital.
Hardy's surgical procedures generally have three fee components: (1) a fee for surgical services provided by the surgeon; (2) a fee for anesthesia services provided by the anesthesiologist; and (3) a fee for the use of a surgical facility and its accompanying services. Patients pay the facility fee separately from Hardy's fee as a surgeon. Facility fees typically include the use of medical equipment, supplies, and staff, who include the front office clerk and the nurses who provide pre- and post-operative care.
Because of the high costs to patients of having surgeries at the local hospitals and the difficulty in booking surgery rooms at them, Hardy considered opening his own surgery center where he could perform any surgeries that he was not required to perform at a hospital. After purchasing land and drawing up plans for a surgery center, he concluded that it would be better to join an already existing surgery center instead of constructing his own. In 2006, he bought an interest in Missoula Bone & Joint Surgery Center LLC (MBJ), at which he could perform his surgeries, except for certain complex procedures and those requiring an overnight stay. MBJ is treated as a partnership for federal tax purposes.
Hardy has never managed MBJ and has no day-to-day responsibilities there. Although he meets with the other members of MBJ quarterly, he does not have any input into management decisions. He generally is not involved in hiring or firing decisions. He receives a distribution from MBJ regardless of whether he performs any surgeries at the surgery center, and his distribution is not dependent on how many surgeries he performs at MBJ. MBJ does not have a minimum surgery requirement to receive a distribution.
In 2006 and 2007, Hardy's accountant reported his income from MBJ on Schedule E, Supplemental Income and Loss, as nonpassive income. However, in 2008, upon learning that Hardy was not involved in the management of MBJ and was not responsible for its debts, the accountant reassessed the characterization of Hardy's income from MBJ and determined that the income was passive. For the years at issue before the Tax Court, 2008 to 2010, he reported the income on Schedule E as passive income and for each year offset passive activity losses carried over from previous years against the income from MBJ.
On audit, the IRS disallowed Hardy's passive activity loss deductions for 2008 to 2010. According to the IRS, the income from MBJ was nonpassive in those years because Hardy had grouped the income from MBJ with the income from his medical practice in 2006 and 2007, and the income from the single activity was nonpassive. Therefore, Hardy had no passive income from which he could deduct his passive losses carried forward from previous years. Hardy challenged the IRS's determination in Tax Court.
The Tax Court's Decision
The Tax Court held that the MBJ income was passive with respect to Hardy, but he could not deduct the passive loss carryforwards from years before 2008 against his income from MBJ in the years 2008-2010. The court found that Hardy had not grouped his MBJ activity with his medical practice activity and that the IRS could not regroup his interest in MBJ and his medical practice as a single activity because his treatment of each as a separate activity was reasonable. The court further found that if Hardy had properly reported his income from MBJ as passive in 2006 and 2007, he would have had no passive loss carryforwards from 2008 that he could deduct in the years 2008 to 2010.
Hardy's grouping of his activities: Hardy had not explicitly grouped his interest in MBJ and his medical practice by reporting his income from MBJ as nonpassive in 2006 and 2007. The IRS nonetheless argued that the Tax Court should infer that he had grouped his interest in MBJ with his medical practice because he treated his MBJ income as nonpassive. The court refused to do so, finding that Hardy's accountant had credibly testified that he did not group the activities and that the mere fact Hardy reported his income as nonpassive was not enough to find that he had grouped the activities.
IRS's regrouping of the activities: The IRS also argued that it could, under Regs. Sec. 1.469-4(f), regroup Hardy's activities. Under that regulation, the IRS can regroup activities if the taxpayer's grouping does not result in an appropriate economic unit and the principal purpose of a taxpayer's grouping (or failure to group) is to circumvent the underlying purposes of Sec. 469. The IRS contended that Hardy's situation was almost identical to the one described in the example in Regs. Sec. 1.469-4(f)(2), in which a medical practice and a business of acquiring and operating X-ray equipment (substantially all of the services of which were provided to the medical practice or its patients) are held to be an appropriate economic unit and cannot be treated as separate activities.
Hardy, on the other hand, argued that his situation was analogous to the one described in Technical Advice Memorandum (TAM) 201634022 (released by the IRS after the trial), in which the IRS approved of a taxpayer's treating income from a surgery center as passive income. In the TAM, the taxpayer was an employee and partial owner of two S corporation medical practices and owned a small interest in a surgical center. The taxpayer was not involved in day-to-day management of the center and could not refer patients to it, and his income from it did not depend on the number of surgeries he performed at it. In addition, the taxpayer, before the opening of the center, performed surgeries in the taxpayer's office or a local hospital and charged separately for medical services rendered. In its analysis, the IRS differentiated the facts in the TAM from the facts in Regs. Sec. 1.469-4(f)(2) and explained that there could be more than one way to group the activities into appropriate economic units.
After analyzing Hardy's situation using the list of facts and circumstances in Regs. Sec. 1.469-4(c)(1) that are given the greatest weight in making the appropriate economic unit determination, the Tax Court found that there was more than one appropriate way to group Hardy's interest in MBJ and his medical practice. Thus, his treatment of them as separate activities was reasonable. In support of this treatment, the court noted that Hardy was the sole owner of his medical practice but only a minority owner in MBJ; he had no management responsibilities for MBJ; he performed different services in his medical practice from those MBJ provided as a surgical center; no employees of his medical practice also worked for MBJ; and he received income for services performed in his medical practice, but his distributions from MBJ were unrelated to services provided.
The Tax Court also concluded that the evidence did not show that Hardy had a principal purpose of circumventing the underlying purposes of Sec. 469 by treating his medical practice and his interest in MBJ as separate activities. The court noted that Hardy did not form MBJ to generate passive losses, as it was already established when he became a member. Also, because he had never been able to provide surgery under general anesthesia in his medical practice's office, he did not convert a portion of his medical practice into a passive activity when he joined MBJ. In addition, his original consideration of opening his own surgery center indicated that his intent in becoming a member of MBJ was not to generate passive losses.
Deduction of the prior-year passive losses: To determine whether Hardy had deducted the correct amount of passive loss carryforwards in the years 2008 to 2010, the Tax Court was required to review the facts for years previous to those before the court to determine the amount of Hardy's passive loss carryover to 2008. The court stated that it could use facts relating to a later year in the process of recomputing a tax liability for an earlier barred tax year in order to arrive at the correct liability for an open year.
The court explained that, because it had already found that Hardy did not group his activities in 2006 and 2007, it came to the "inescapable conclusion" that he had incorrectly treated his income from MBJ as nonpassive in those years. Moreover, if Hardy had correctly reported the MBJ income as passive for 2006 and 2007, the income would have fully absorbed his available passive losses in those years, and there would not have been any passive losses to carry forward to 2008 and later years. Accordingly, he was not entitled to the passive losses claimed in 2008 to 2010 that stemmed from passive losses carried forward from previous years.
Reflections
Even though Hardy prevailed on the main issue in the case, because the statute of limitation had run on his returns for 2006 and 2007, he was left unable to amend his returns for those years. This prevented him from benefiting from the passive losses that the Tax Court found had been absorbed in those years. It is worth noting that a brief investigation by the tax practitioner into the nature of Hardy's relationship to MBJ when Hardy's 2006 return was being prepared could have prevented these problems.
When a client gives a practitioner a new K-1 for an interest in a partnership or a limited liability company that is passing through a material amount of losses or income that allows the client to use passive losses, the practitioner should always thoroughly question the client to ensure that the characterization of the interest as passive or nonpassive is correct. In this case, the practitioner was aware of the relevant passive activity rules but initially did not dig deeply enough to get all the facts needed to correctly apply the rules to Hardy's interest in MBJ.
Hardy, T.C. Memo. 2017-16
