Understanding IRS Encouragement of PLRs for Healthcare Entities and Assessing Healthcare Corporate and Tax Structure For Tax Compliance
Date: November 11, 2024
What is a PLR?
A PLR is a written decision by the IRS in response to a taxpayer's request for guidance on their specific tax issues and can only be relied upon by the taxpayer requesting the PLR. PLRs are beneficial because they provide clarity and certainty on how the IRS will treat particular transactions or arrangements, allowing the requesting taxpayer to proceed with confidence. However, obtaining a PLR can be time-consuming and costly. The process involves preparing a detailed submission, often with the assistance of legal and tax professionals, and waiting for the IRS to review and respond. Despite these drawbacks, the benefits of having a clear understanding of tax obligations and avoiding potential disputes with the IRS often outweigh the costs. Even though PLRs are binding only on the taxpayer who received the private letter ruling, they provide insight into the current reasoning and analysis of the IRS.
The Friendly PC Model
The friendly PC model, also known as the friendly doctor model, involves a licensed physician owning the legal title to a professional corporation (PC), while a management service organization (MSO) handles the administrative and managerial aspects of the practice. This structure is designed to comply with state laws that prohibit non-physicians from owning medical practices. The MSO typically enters into a management agreement with the PC, providing services in exchange for a fee and often exerting significant control over the PC's operations.
Effect of Management Services Agreements Between MSOs and PCs on Determination of Beneficial Ownership
Management agreements between MSOs and PCs significantly impact the determination of beneficial ownership for tax purposes. These agreements often grant the MSO control over the PC's economic benefits and decision-making authority, which the IRS recognizes as beneficial ownership. This determination allows the PC to be included in the MSO's consolidated tax return, provided the arrangements comply with state laws and meet the criteria for an “affiliated group” outlined in Section 1504(a)(1) of the Internal Revenue Code.
Benefits of Consolidated Tax Filings
Consolidated tax filing can offer significant advantages for an MSO and a PC operating under a "friendly doctor" or "friendly PC" model. One of the primary benefits of a consolidated tax filing is the ability to offset the income of one entity with the losses of another within the same affiliated group. This can be particularly advantageous in the healthcare sector, where the financial performance of different entities can vary significantly. Filing a consolidated tax return also simplifies the tax compliance process by allowing the affiliated group to file a single return instead of multiple separate returns. This can reduce administrative burdens and costs and streamline tax reporting. Consolidated tax filing can improve cash flow management by allowing the group to optimize the timing and amount of tax payments. This can be particularly beneficial for managing the financial health of the entire group. For example, the group can better manage its tax liabilities and take advantage of tax planning opportunities, such as deferring income or accelerating deductions, to improve cash flow.
Additionally, consolidated tax filing allows for more tax-efficient intercompany transactions, such as loans, asset transfers, and service agreements. These transactions can be structured to minimize tax liabilities and optimize the financial performance of the group. For example, the MSO can provide loans or transfer assets to the PC without triggering immediate tax consequences, as these transactions are considered internal to the consolidated group. This flexibility can be used to support the financial needs of the PC and enhance the overall efficiency of the group. Lastly, consolidated tax filing enables the group to utilize tax attributes, such as net operating losses (NOLs) and tax credits, more effectively. These attributes can be shared among the entities within the group to reduce the overall tax burden.
At the same time, there are certain risks and limitations when filing consolidated returns. Filing consolidated returns involves, among other things, preparing detailed statements and schedules for each member of the group, reconciling any surplus, and preparing consolidated balance sheets. This can increase the risk of errors and omissions, so it is important to work closely with the group’s CPA and other professional tax advisors. Also, each member of a consolidated group is liable for the tax computed for the consolidated return year, meaning that the IRS can collect the full amount of tax due from any member of the group, not just the common parent. Finally, once a group has filed a consolidated return for a taxable year, it must continue to file consolidated tax returns unless it can elect to discontinue filing consolidated tax returns under specific conditions outlined in the Treasury Regulations.[iii]
Elements Examined To Determine Beneficial Ownership
Management agreements between MSOs and PCs typically include several key elements that influence the determination of beneficial ownership to elect for a consolidated tax filing:
- Administrative and Support Services: The MSO provides comprehensive administrative and support services to the PC, including billing, human resources, and facility management. This arrangement allows the MSO to control significant aspects of the PC's operations.
- Economic Control: The MSO often receives a management fee and may also be entitled to a share of the PC's profits. This economic arrangement indicates that the MSO bears the financial risks and rewards associated with the PC's operations.
- Restrictions on Share Transfers: The agreements usually include provisions that restrict the PC's shareholder from transferring shares without the MSO's consent. In some cases, if the shareholder attempts to transfer shares without obtaining the MSO’s consent, the stock automatically transfers to a designated transferee chosen by the MSO for a nominal amount.
- Control Over Major Decisions: The MSO may have the authority to approve or veto significant decisions made by the PC, such as declaring dividends, issuing additional shares, or entering into mergers and acquisitions. This level of control further supports the MSO's beneficial ownership.
The primary ambiguity surrounding the friendly PC model has been whether the MSO's control over the PC constitutes beneficial ownership for tax purposes. Beneficial ownership implies that the MSO, despite not holding legal title, has the benefits and burdens of ownership, such as control over economic benefits and decision-making. This distinction is crucial for determining whether the PC can be included in the MSO's consolidated tax return and has been the subject of several PLRs.
The 2014 Private Letter Ruling
In 2014, the IRS issued PLR 201451009 in which it determined that a management services company and two professional corporations were permitted to join in filing a consolidated federal income tax return as members of the same affiliated group.[iv] The ruling was based on the concept of beneficial ownership, where the management company controlled the PCs through contractual arrangements, despite not holding legal title to the shares of the PCs.
In this PLR, the IRS discusses that for a corporation to be a member of an affiliated group, Section 1504(a)(1) of the Internal Revenue Code requires 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.[v] The IRS did not discuss the “direct ownership” of stock requirement in this PLR; however, it has been interpreted by many as implying that the management company was the beneficial owner of the PCs’ shares even though the professionals, as required by applicable state law, held the legal title of such shares. Although the IRS provided minimal analysis, it appears critical that the management company, the PCs, and the professional shareholders of the PCs entered into stock transfer restriction agreements under which the professional shareholders could not transfer their shares without the MSO’s consent, the PCs could not make distributions or issue additional equity, and the MSO had the right to consent to any liquidation of the PCs. Therefore, it appears that the IRS’s stance is that, under these contractual arrangements, beneficial ownership of the PCs’ shares satisfied the requirements of Section 1504(a) of the Internal Revenue Code.[vi]
This ruling was significant as it provided a precedent for other healthcare companies using similar structures to consolidate their tax filings.
The 2020 Private Letter Ruling
In 2020, the IRS issued PLR 202049002, which reaffirmed the principles established in the 2014 ruling. The ruling allowed a PC to join a parent group's consolidated federal income tax return, based on the company's control over the PC through agreements that restricted the transfer of shares and economic benefits.[vii] Here, if the professional shareholder violated the stock transfer restrictions, the stock would automatically transfer to a transferee eligible to hold the stock under the state’s professional licensing regulations selected by the parent entity for a nominal consideration. This ruling further solidified the IRS's stance on recognizing beneficial ownership in friendly PC structures for tax purposes.
2021 and 2022 Requests for Comment
In 2021 and 2022, the IRS requested comments on the friendly doctor arrangements, seeking input on how to provide clearer guidance. The American Bar Association's tax section responded, urging the IRS to issue a revenue ruling that would provide precedential guidance on when professional corporations could file consolidated returns as part of an affiliated group.[viii] The ABA emphasized the need for enforceable contractual agreements under state law to establish beneficial ownership.[ix]
Guidance and Updates in April 2024
In April 2024, the IRS issued PLR 202417008, which again addressed the friendly PC model arrangement in detail. The ruling allowed two professional corporations to become members of a parent group and required them to join in filing consolidated tax returns upon the execution of support services and stock transfer agreements.[x] This ruling provided further clarity on the requirements for beneficial ownership and the conditions under which professional corporations can be included in consolidated tax filings consistent with the prior PLRs.
Outstanding Guidance and Future Needs
Despite the progress made through these PLRs, there is still a need for more comprehensive and precedential guidance from the IRS. Healthcare practices and investors would benefit from a revenue ruling that clearly outlines the criteria for beneficial ownership and the conditions under which PCs can be included in consolidated tax returns. Rulings are publicly available and provide broad guidance on the IRS's interpretation of tax laws that can be relied upon by all taxpayers, not just the one who requested the ruling. They can also be cited as precedent in tax disputes, which would reduce the need for individual PLR requests, saving time and costs for taxpayers and the IRS and providing greater certainty in structuring healthcare transactions.
Interplay for IRS Guidance, Corporate Practice of Medicine, and Anti-kickback Statue
Even with the IRS's determination of beneficial ownership and control in the context of MSOs and PCs, deals and corporate structures must still be evaluated for specific healthcare law compliance, including the corporate practice of medicine, anti-kickback laws, and referral regulations. Understanding these impacts is crucial for healthcare entities and investors to ensure compliance with both tax and healthcare laws.
Anti-kickback Statute
The federal Anti-Kickback Statute (AKS) prohibits the exchange of remuneration to induce or reward referrals for services covered by federal healthcare programs. The IRS's recognition of beneficial ownership in MSO-PC arrangements does not directly address compliance with the AKS. However, the structure of these arrangements must be carefully designed to avoid implicating the AKS. For instance, the management fees paid to the MSO must be at fair market value and not tied to the volume or value of referrals.
The management agreements at issue in PLR 201451009 between the MSO and the PCs included provisions for administrative fees and potential bonuses. These financial arrangements must be structured to comply with the AKS by ensuring that they reflect fair market value for the services provided and do not incentivize referrals. The IRS, of course, does not address AKS when reviewing a taxpayer's request for guidance on their specific tax issues.
Corporate Practice of Medicine
The corporate practice of medicine prohibits non-physicians from owning or controlling medical practices. This doctrine exists to ensure that medical decisions are made by licensed professionals exercising their professional judgment rather than investors with a profit motive. Many states have strict regulations that require medical practices in particular to be owned and controlled by licensed physicians.
It appears that in the above-discussed PLRs, the IRS does not take into account or undergo an analysis of whether the proposed deal and structure are compliant with state corporate practice of medicine laws and, rather, relies on taxpayer representations that the arrangement is required by state laws or regulations. In the 2014 PLR 201451009, the taxpayer represented that applicable state law did not prohibit the beneficial ownership of stock in each PC by the management company, and the IRS did not opine on this further. The IRS's determination of beneficial ownership allows MSOs to exert control over PCs through management agreements without violating state corporate practice of medicine laws. By structuring the relationship such that the MSO has the benefits and burdens of ownership, the IRS recognizes the MSO as the beneficial owner for tax purposes, even though the legal title remains with the licensed physician. This arrangement complies with state laws while allowing the MSO to include the PC in its consolidated tax return.
For example, in PLR 202049002, the IRS ruled that a PC could join a parent group's consolidated federal income tax return based on the MSO's control over the PC through agreements that restricted share transfers and economic benefits. This ruling demonstrates how beneficial ownership can be structured to comply with state corporate practice of medicine laws while achieving tax consolidation.
Implications for Medical Practices and Investors
In conclusion, while the IRS has made significant strides in clarifying the tax treatment of friendly doctor arrangements through PLRs such that they can maintain favorable and compliant treatment with other applicable laws, there remains a need for more definitive and broadly applicable guidance. In the absence of current guidance, it is recommended that practices and investors do the following to maintain compliance:
- Ensure compliance with federal regulations in addition to the Internal Revenue Code, such as the AKS and the Stark Law. These laws govern financial relationships and referrals within healthcare and require that compensation arrangements be at fair market value and not tied to the volume or value of referrals.
- The MSA should detail the MSO's authority over significant decisions, such as declaring dividends and other distributions, transferring and issuing shares, and entering into mergers. This level of control supports the MSO's beneficial ownership for tax purposes.
- Ensure that stock transfer agreements are legally enforceable under state law. The agreements must comply with state-specific regulations regarding the ownership and control of medical practices.
- Prepare a detailed submission for the PLR request, including descriptions of the management agreements, stock transfer restrictions, and compliance with state laws. This submission should be accompanied by penalties of perjury statements executed by an appropriate party.
- Section 482 of the Internal Revenue Code requires that related party transactions, including those under the MSA, be structured as arm's length transactions. To demonstrate this, PCs and MSOs should maintain and update benchmarking studies and valuations to support the fee structures used.
Structuring private equity deals in healthcare transactions to maintain both tax and regulatory compliance can be meticulous. If you are unsure of how to structure a deal or would like additional information, please contact Rachel Carey at rcarey@whitefordlaw.com and Jordan Halle at jhalle@whitefordlaw.com.
[i] Erin Schilling, IRS Encourages Companies to Ask for 'Friendly Doctor' Rulings, Bloomberg Law News (Sept. 30, 2024), https://www.bloomberglaw.com/bloomberglawnews/daily-tax-report/.
[ii] This article addresses only U.S. federal income tax returns. Other tax compliance obligations, such as state income tax returns and employment tax returns, are beyond the scope of this article.
[iii] See Treas. Reg. § 1.1502-75(c)
[iv] I.R.S. Priv. Ltr. Rul. 201451009 (Dec. 4, 2014)
[v] Id.
[vi] Id.
[vii] I.R.S. Priv. Ltr. Rul. 202049002 (Sept. 8, 2020)
[viii] https://www.americanbar.org/content/dam/aba/administrative/taxation/policy/2021/111821comments.pdf.
[ix] Id.
[x] I.R.S. Priv. Ltr. Rul. 4 202417008 (Nov. 8, 2023)
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