Income from professional corporations (“PCs”) owned beneficially by an exempt hospital and owned nominally by physicians employed by the hospital was treated by the IRS as unrelated business income in a recent private letter ruling. Having determined that the exempt hospital controlled the PCs within the meaning of section 512(b)(13) of the Internal Revenue Code (the “Code”), the interest accrued by the hospital from the PCs pursuant to loans and advances constituted gross income derived from an unrelated trade or business to the hospital. Priv. Ltr. Rul. 200716034 (Apr. 20, 2007) (“Ruling”).

The IRS found that the exempt organization held all significant rights granted by stock ownership in the PCs through (a) a shareholder’s agreement that provided that the physician would (i) sell the stock to the hospital’s nominee in exchange for nominal consideration; (ii) remain employed by the hospital through the PC; and (iii) not otherwise sell, transfer or encumber the PC stock; (b) an employment agreement that requires a physician to give the hospital any income received from the PC; and (c) an affiliation agreement pursuant to which the hospital provided professional, administrative and management services to the PC, despite the hospital’s concession that the agreements were unenforceable under state corporate practice of medicine laws. The IRS’s determination was based upon the fact that (a) the parties have acted in accord with the Agreements; (b) the parties intend to continue to honor the Agreements; (c) the parties have honored similar Agreements in the past; and (d) there is no economic incentive for a physician not to honor the Agreements. Based upon the foregoing, the IRS held that the hospital was a controlling organization for the PCs under section 512(b)(13) of the Code.

The IRS then found that the income from the PCs was unrelated business income because the PCs served their own patients rather than the hospital’s patients and because the PCs carried on activities on a larger scale than was reasonably necessary for the hospital’s performance of its exempt functions. Finally, the IRS ruled that the receipt or accrual of interest by the hospital is gross income derived from an unrelated trade or business to the extent it reduces the PCs’ net unrelated income (or increases their unrelated loss).

This private letter ruling serves as an important reminder that certain payments from a taxable controlled entity to an exempt controlling entity may result in unrelated business income.