On April 20, the IRS released a new Private Letter Ruling (PLR 200716034, Jan. 26, 2007) that likely will come as a surprise to those in the exempt healthcare sector who closely followed the integrated delivery system rulings issued in the mid-1990s and since.
The new PLR involves an integrated healthcare delivery system, which includes a parent entity (“Parent”), a hospital (“Hospital”), and a number of controlled taxable professional corporations (“PCs”). The stock of the PCs is held by licensed physicians employed by the Hospital. This structure was necessitated by state law, which provides that only licensed physicians may hold the stock of professional corporations engaged in the practice of medicine. As with typical “captive PC” models, the Hospital, the PCs and the physician-shareholders had entered into employment agreements, shareholder agreements, and affi liation agreements that collectively resulted in the Hospital having effective control over, and benefi cial interest in, the PCs.
The ruling focuses on the characterization of payments of interest by the PCs to the Hospital and the Parent under Internal Revenue Code Section 512(b)(13) and, specifi cally, whether such amounts should be deemed to constitute unrelated business income (“UBI”) to the Hospital or Parent. Ultimately, the IRS concludes that such amounts should be treated as UBI. Without regard to that particular conclusion, the rationale employed by the IRS is confounding, and appears to be inconsistent with many past rulings. Specifi cally, the IRS concludes that patients of the PCs are not patients of the Hospital, such that the PCs’ provision of professional medical services through employed physicians does not have a substantial causal relationship to the achievement of the Hospital’s exempt purposes. This approach seems diffi cult to reconcile with innumerable prior IRS rulings holding that patients of one entity within an integrated system are to be treated as patients of all entities within that system.
Moreover, there can be little doubt that the PCs here are “related” to the Hospital and the Parent for income tax purposes – the IRS in fact reaches that conclusion in the ruling by determining that the Hospital holds the benefi cial interest in the PCs and thus is a controlling organization in relation to the PCs for purposes of Section 512(b)(13)(A).
The ruling notes that certain of the PCs are S corporations, but does not provide further comment or analysis on that issue. Given the conclusion that the Hospital holds the benefi cial interest in the PCs, as to those PCs that are S corporations, it would seem that the Hospital should be reporting all of its fl ow-through income as UBI pursuant to Section 512(e)(1), rendering the Section 512(b)(13) analysis moot. Healthcare tax experts have criticized the ruling. Absent an IRS reconsideration, tax-exempt healthcare systems should review the new ruling and consider its implications for their particular facts and plans. Equally importantly, organizations should watch carefully for future IRS rulings, which should allow us to determine whether PLR 200716034 represents a true change in the IRS’s analytical approach or, rather, a mere anomaly.