Although hospitals and other charitable organizations described in Internal Revenue Code (“Code”) section 501(c)(3) are generally exempt from federal income tax, they are not exempt from the “unrelated business income tax.” The “UBIT” subjects income derived from an unrelated trade or business activity to tax at the normal corporate rates.

A controversial private letter ruling just issued by the Internal Revenue Service (“Service”) could have serious tax consequences for hospitals that employ their physicians through affiliated professional corporations (“PC”). PLR 200716034, issued April 23, 2007, concluded that income generated by affiliated PCs would constitute unrelated business taxable income (“UBTI”) with respect to the hospital, and thus interest payments made by the PCs to the hospital were taxable to the hospital. The ruling’s conclusion was unexpected, and the basis for that conclusion seems to be inconsistent with what most practitioners believed, based on prior Service rulings, was the correct interpretation of the law. Many hospitals, particularly those in jurisdictions that retain the corporate practice of medicine doctrine, have utilized the “friendly PC” model to employ physicians on the hospital’s medical staff. As a result, the ramifications of the ruling could be both far reaching and expensive.

Facts of the Ruling

The hospital was a part of a large health care delivery system having a nonprofit parent corporation as the controlling entity. The ruling involved six PCs established and funded (principally through loans and advances) by the parent to employ physicians practicing in comprehensive health services, surgical services, cardiovascular and thoracic surgery, radiology, family medicine and pediatrics. The hospital was located in a corporate practice of medicine state and, therefore, the stock of each PC was owned by physicians employed by the hospital under a written employment agreement. The hospital and each PC had an affiliation agreement in which the hospital agreed to provide management and administrative services to the PC. The physician also entered into a shareholder agreement that restricted the physician’s ability to transfer stock in the PC. Interestingly, the ruling stated that none of the patients of the six PCs was a patient of the hospital.

IRS Analysis

After examining the relevant agreements among the hospital, physicians and PCs, the Service concluded that the physicians were merely acting as the hospital’s nominees and were not beneficial owners of the PCs. The Service reached that conclusion, even though ownership of the PC by a non-physician was prohibited under applicable state law, because of the business reality and intention of the parties. Based on that conclusion, the Service determined the hospital controlled each of the PCs within the meaning of § 512(b)(13)(A) of the Code. That Code section subjects certain payments of annuities, interest, royalties or rent made by a controlled organization to a controlling organization to tax as UBTI.

The Service also stated, “The PCs’ provision of medical services to their own patients does not have a substantial causal relationship to the achievement of Hospital’s exempt purposes. . . . Thereby, the PCs are conducting their activities on a larger scale than is reasonably necessary for the performance of Hospital’s exempt functions. . . . Consequently, the PCs are engaged in an unrelated trade or business with respect to Hospital. Therefore, the PC’s income (or loss) from providing medical services to its patients, less applicable deductions, is ‘net unrelated income’ (or ‘net unrelated loss’) within the meaning of § 512(b)(13)(B) of the Code.” The Service did not elaborate on its reasons for concluding the PCs’ activities were excessive in scope and lacked causal relationship.

Consequences

The ruling’s conclusion that the PCs were controlled by the hospital and engaged in trade or business activities that were unrelated to the hospital’s exempt purposes would impede the hospital’s ability to receive, tax free, the net income generated by the PCs. In a typical arrangement, a controlled entity would make tax deductible payments to the controlling organization of interest on loans, rent or royalties, in amounts sufficient to eliminate any taxable income at the controlled entity level. If those payments are made to a tax-exempt entity, such as a hospital, then the payments would be deductible by the payor but not taxed to the payee. Code section 512(b)(13) frustrates that scheme by characterizing certain annuity, interest, rent or royalty payments (which generally are exempt from the unrelated business income tax) as UBTI if the payments are made by a controlled entity engaged in a business unrelated to the controlling organization’s exempt purposes. The ruling concluded the interest payments made by the PC to the parent would be taxable to the parent on that basis. The PCs in the ruling were treated as taxable corporations and had filed a standard corporate income tax return. If the PCs decided not to make interest payments because of their potential characterization as unrelated business taxable income, then the taxable income of the PC would be increased by the amount of the foregone interest deduction. The Service’s position effectively would tax the net income generated by PCs employing hospital physicians.

Discussion

The ruling’s unusual result might well be predicated upon the (almost unbelievable) fact that no single patient of a PC was also a patient of the hospital. In prior rulings, the Service has “followed the patient” in its analysis of the UBIT consequences of providing ancillary services. For example, in a familiar ruling, the Service concluded the provision of laboratory services by a hospital to that hospital’s patients was a related function, but the provision of those same laboratory services to patients of other hospitals was not. In the former case, income would be tax exempt; in the latter case, any income derived would be taxable as UBTI. However, in no previous case has the Service made such a distinction when the health service involved was direct, handson patient care. Indeed, the Service has ruled that income derived from a hospitalaffiliated medical office building was related, and therefore, exempt income because of the medical office building’s proximity to the hospital. The permuted logic underlying the ruling is apparent in light of the Service’s conclusion that the hospital controlled the PCs. In numerous joint venture and similar rulings, a hospital’s ability to control the activity was the essential factor in reaching a related versus unrelated decision. If a hospital could demonstrate control over a patient-care activity, it was presumed the income derived from the patients would be related to the hospital’s exempt purposes. If the hospital could not demonstrate control, the income likely would be characterized as UBTI. If a hospital, in fact, controls a PC used to employ hospital physicians, then generally the activities of the physicians, i.e., patient care, would be attributed to the hospital for UBIT purposes. Because patient care (the promotion of health for the benefit of the community) is the essential basis for a hospital’s exemption, it is hard to imagine an activity that is more related to a hospital’s exempt purposes. The “follow the patient rule” applied to ancillary services ought not to enter into the equation. Unfortunately, the Service seems to have employed a hybrid approach in which any hospital-controlled activity must be limited to the hospital’s own patients in order to be a related activity. It is doubtful the Service intended such a broad result, but the ruling certainly has muddied the water.

Planning

The PCs involved in the ruling were organized as for-profit stock corporations because of the state’s corporate practice of medicine doctrine. The Service has acknowledged in the past that the state law requirement should not dictate federal tax consequences. As a result, the Service has ruled that a physician owned PC can qualify as a taxexempt § 501(c)(3) organization under circumstances similar to those posited in the ruling. Hospitals utilizing affiliated PCs ought to pursue a § 501(c)(3) determination for those PCs if they have not already done so. The tax uncertainty generated by the ruling could be eliminated by obtaining a separate determination for each PC. Presumably, obtaining such a determination would require a PC to distinguish its facts from those in the ruling. If a PC could demonstrate the patients its physicians treated also were patients of the controlling hospital, then the Service ought to issue a favorable determination, as it has done in the past.

Other arrangements involving affiliated entities also should be evaluated in light of the ruling. If a hospital controlled entity provides services to persons who are not hospital patients, there is potential exposure to the unrelated business income tax. Proactive measures can identify and subsequently mitigate those risks. Conversely, a “do nothing” approach conceivably could result in the imposition of interest and penalties, in addition to the tax owed.