The IRS recently issued PLR 201451009, providing that a management services company and two professional corporations (PCs) were members of the same affiliated group under Section 1504(a) of the Internal Revenue Code (“Code”), and thus permitted to join in the filing of a consolidated federal income tax return. In that letter ruling, the management company did not legally own the PC shares but controlled the PCs through contractual arrangements.
The IRS, by issuing this letter ruling, appears to sanction non-physician-owned corporations and physician-owned PCs being members of an affiliated group and joining in the filing of a consolidated federal income tax return based on “beneficial” rather than “legal” ownership of the shares of the PC that amounts to at least 80 percent control over the value and voting of the shares in satisfaction of Code Section 1504(a). This private letter ruling is significant for every healthcare company that utilizes a “friendly” PC in its business structure because it would allow the operations of the physician practice to be consolidated with the management services company for tax purposes, thus allowing any losses of the physician practice to offset income of other members of the affiliated group.
Corporate Practice of Medicine and “Friendly” PC Structures
Many healthcare companies use a “friendly” PC structure in order to comply with the “corporate practice of medicine” rules existing in many (but not all) states. These rules generally prohibit a business corporation from practicing medicine or employing a physician to provide professional medical services. Under most PC laws, only professionals who are licensed in that state may own shares in the PC and serve as directors of the PC. Other licensed professionals have similar constraints (e.g., dental and physical therapy).
The typical “friendly” PC structure involves the following: a licensed physician (rather than the management company) owns all of the stock of the PC , and that PC, in turn, provides the professional services in that state. The management company and the PC enter into a management agreement whereby the management company provides management and other administrative services for the PC in exchange for a management fee. In addition, the management company, the PC and the physician owner of the PC may enter into other agreements designed to give the management company as much control over the PC as is permitted under applicable state law. These arrangements vary widely and require a detailed, state-specific analysis of the individual facts of each situation.
Discussion of PLR 201451009
In PLR 201451009, a business corporation (“Parent”) was the common parent of an affiliated group of corporations filing a consolidated federal income tax return (“ParentGroup”). Parent, through wholly-owned LLCs, owned all of the stock of a subsidiary corporation (“Management Co”), which was a member of the Parent Group. Also, an individual (presumably a “friendly” physician) (“Shareholder”) was the sole shareholder of two PCs. Under applicable law for each state, the PCs could engage in the delivery of professional services solely through one or more professionals, and the shares of the PCs generally could only be issued to, held by, or transferred to a professional. Shareholder was a licensed professional in each state and authorized to provide such professional services. As described below, Shareholder, Management Co, and each PC entered into a series of contracts to give Management Co control over the PCs.
Each PC entered into a support service agreement with Management Co, pursuant to which Management Co performed all administrative and support services on behalf of the PCs in exchange for a fee. Management Co also managed the PCs to the extent such management did not constitute engaging in the profession under applicable state law.
Shareholder and Management Co entered into a director agreement whereby Shareholder served as the professional director for each PC. Management Co had the right to terminate the director agreement for any reason, without penalty and at any time upon notice to Shareholder. The termination of the director agreement was a “transfer event” under each of the stock transfer restriction agreements (discussed below).
Shareholder paid a nominal amount to acquire legal title to all of the issued and outstanding shares of the PCs and the ownership of such shares were subject to stock transfer restriction agreements. Management Co and Shareholder entered into stock transfer restriction agreements with each PC. The agreements prevented Shareholder from: (i) transferring or disposing of any shares of the PCs, except as provided in the agreements; (ii) causing or permitting a PC to make a dividend or other distribution with respect to its stock or issue additional equity interests or rights to acquire additional equity interests; and (iii) consenting to a liquidation or dissolution of a PC without the consent of Management Co.
Additionally, the stock transfer restriction agreements required Shareholder, upon the occurrence of certain “transfer events” set forth in the agreements, to transfer all of the shares of the relevant PC to another professional or entity that was identified by Management Co. Such transfer events included, but were not limited to: (i) the impermissible transfer of PC shares; (ii) Shareholder ceasing to be a director of the PC; (iii) the termination of the support services agreement with or without cause; (iv) the dissolution of the PC; and (v) Shareholder breaching a covenant in any agreement with Management Co.
Further, the bylaws of each PC provided that any person who transfers, holds or purports to exercise any rights or privileges with respect to shares of the respective PC in violation of the stock transfer restriction agreements and the bylaws shall not have the right to vote, receive dividends or exercise any right or privilege as a holder of PC shares.
In the event Management Co desired to terminate the existence of a PC, Management Co intended to effect such termination by: (1) causing a “transfer event” by terminating the director agreement; (2) pursuant to the relevant stock transfer restriction agreement, requiring Shareholder to transfer all shares of the relevant PC to Management Co in exchange for the nominal amount that Shareholder originally paid for such shares; and (3) liquidating or merging the relevant PC into Management Co., so that all of the assets of such PC will be transferred to Management Co.
The IRS ruled, with minimal analysis, that both PCs were members of Parent’s affiliated group under Section 1504(a) of the Code, and were permitted to join in the filing of a consolidated federal income tax return with the Parent Group.
Observations – Meaning of “Direct Ownership”
Section 1504(a) of the Code requires that, in order for a corporation to be a member of an affiliated group, the common parent or another member of the affiliated group must “directly own” stock in the includible corporation that represents 80 percent or more of the corporation’s total voting power and that has a value equal to at least 80 percent of the total value of the corporation’s stock. Although the IRS did not discuss the “direct ownership” of stock requirement in the PLR, the ruling implies that Management Co was the beneficial owner of the PC shares, notwithstanding Shareholder’s legal ownership of such shares, and that such beneficial ownership of the PC shares satisfied the requirements of Section 1504(a) of the Code. Interestingly, the taxpayer in PLR 201451009 represented that applicable state law did not prohibit the beneficial ownership of stock in each PC by Management Co.
In the PLR, the IRS cited Rev. Rul. 84-79, 1984-1 CB 190 where the IRS ruled that parent corporation “directly” owned all of the stock of a corporate subsidiary notwithstanding the fact that parent corporation had transferred all of the subsidiary stock to a revocable voting trust. In that revenue ruling, the IRS discussed relevant authority and reasoned that beneficial ownership of property whereby the beneficial owner exercises dominion over the property satisfies the “direct ownership” requirement of Section 1504(a) of the Code. Accordingly, the IRS’s holding in PLR 201451009 appears to be consistent with its reasoning in Rev. Rul. 84-79.
Tax Planning Opportunities
Private letter rulings are binding only on the taxpayer who received the private letter ruling; however, they provide insight to the current reasoning and analysis of the IRS.
Based on PLR 201451009, a healthcare company may be able to consolidate the operations of its “friendly” PC if it exerts sufficient control over the PC. Some of the key benefits of such consolidation for a healthcare company are that (i) any losses of the physician PC could offset income of other members of the affiliated group, and (ii) it will be more tax-efficient to transfer cash among the members of the affiliated group. Any healthcare company with a “friendly” PC should examine its structure and applicable state professional corporation laws to determine whether its management company can possess a sufficient amount of control over the PC and beneficially own the shares of the PC to satisfy the necessary tax requirements for consolidation. In addition, the company should consider whether the inclusion of its “friendly” PC in its consolidated federal income tax return could be viewed as a violation of any applicable state corporate practice of medicine laws.