A new private letter ruling from the IRS could potentially lead to significant tax savings for companies providing management and support services to physician, dental or other professional practices. In short, the private letter ruling offers the opportunity to structure “friendly PC” model relationships with the strategic aim of either including the PC in the consolidated tax return filed by a management services company (“Manager”) or structuring the relationship to avoid inclusion in such consolidated tax return. State corporate practice restrictions will need to be evaluated when considering the feasibility and the specific benefits and liabilities.
Why Is this Important?
The ability to include the PC in the consolidated federal (and in many states, state) income tax returns can produce tax savings and tax compliance simplification.
- In the start-up stage of a new operation, the PC may well operate at a loss. This loss has traditionally been trapped at the PC level where it would not be used currently or perhaps ever as the ongoing deduction for management fees may leave little, if any, taxable income in the PC in later years. A consolidated return permits the current use of the loss by the Manager’s affiliated group.
- In addition, on an ongoing operational basis, there may be a mismatch between the annual management fee and the PC’s taxable income after the compensation to the licensed professionals. This mismatch will either (i) produce a tax loss that is trapped at the PC level or (ii) produce taxable income which requires the PC to retain cash for such tax that would otherwise be used to pay the licensed professionals or the Manager. The inclusion of the PC in the consolidated income tax return of the Manager eliminates this potential mismatch and results in a single level of current income tax.
- The use of a consolidated income tax return also means that each PC does not file a separate federal (and for most applicable states, state) income tax returns.
On the minus side, the inclusion of the PC in the consolidated income tax returns of the Manager may be viewed negatively by the courts and regulatory authorities in states with strong corporate practice laws and doctrines.
Background on the Private Letter Ruling
The private letter ruling (PLR), issued on Friday, December 19, 2014, addresses the inclusion of two professional corporations (PCs) in the consolidated income tax return of a C corporation parent of a Manager. The facts covered by the PLR include:
- A licensed professional (“the shareholder”) held the stock in the two PCs.
- Each PC had entered into a professional support services agreement (the “service agreement”) with the Manager to receive nonclinical services such as billing, financial reporting, information systems, etc.
- The shareholder and the Manager are parties to a director agreement whereby the shareholder is the professional director of the PC and oversees and coordinates the business objectives for the PC.
- The Manager can terminate the director agreement without cause or penalty.
- The termination of the director agreement is a transfer event under a stock transfer restriction agreement (“restricted stock transfer agreement”) the existence of which is recorded on the stock certificates of the PC.
- The by-laws of the PC require compliance with the restricted stock transfer agreement which prohibits transfers of the stock other than in accordance with the its terms and prohibits the payment of dividends, the issuance of additional shares, or the liquidation or dissolution of the PC without the consent of the Manager.
- Upon the occurrence of certain enumerated events, the shareholder must transfer or will be deemed to transfer all of the shares of the PC to another licensed professional designated by the Manager.
- Upon the determination to liquidate either of the PCs, the Manager will terminate the director’s agreement thereby triggering a transfer event, and the shareholder will cease being a shareholder.
- The stock in the liquidated PC will be transferred to the Manager for the shareholder’s original nominal investment; the PC will be liquidated or merged into the Manager; and all of the PC’s assets will be transferred to the Manager.
- It was represented to the IRS that the applicable law does not prohibit the beneficial ownership of stock in a PC by the Manager and the contracts were enforceable.
The representations that the IRS required are critical and will color the content and structure of the various agreements between the Manager, the PC, the licensed professional, and the PC by-laws.
By treating the Manager as the beneficial owner of the stock for purposes of the C corporation consolidated federal income tax rules, all income, gain, loss, etc. of the PC will be reflected in the consolidated tax return or the Manager. As discussed above, start-up or other losses of a PC will be able to be used by the consolidated group on a current basis instead of largely being trapped at the PC level. Any differences between the taxable income of the PC before the management fee and the deduction for the management fee become irrelevant. The PC will not be required to retain funds or defer management fee payments in order to have cash to pay the federal (and in states that follow the federal rules, state) income taxes. This also means that separate federal and perhaps state income tax returns for the PCs will not be required to be prepared and filed.
Potential Collateral Tax Consequences
The PLR only deals with a C corporation Manager group and PCs. The tax ownership analysis of the PLR means an S corporation PC will not be treated as an S corporation but as a C corporation as the Manager will not be a permitted shareholder. The logic of the PLR indicates that under analogous circumstances the Manager in an MSO relationship with a PLLC or PLLP may be considered the sole federal income tax owner of the PLLC or PLLP under the same circumstances as discussed in the PLR wih respect to PCs, resulting in the PLLC or PLLP being treated as a disregarded entity with its taxable income, gain and loss reported on the Manager’s tax return. Importantly, an extension of the rationale of the PLR to PLLCs and PLLPs is by analogy only. The PLR is strictly a C corporation consolidated return analysis.
Potential Negative Corporate Practice and Other Considerations
As discussed above, the concept that the Manager or the Manager’s corporate affiliated group owns the beneficial ownership of the PC stock for income tax purposes may be viewed unfavorably by regulators and courts in light of a state’s specific corporate practice laws and doctrines even though federal tax law and state non-tax law are often conceptually very different. For example, the tax concept that a single member LLC is disregarded for federal income tax purposes is completely contrary and alien to the state law entity concept that the LLC is a separate legal entity which provides its owners with limited liability. For federal income tax law such an LLC is a “nothing” and for state (non-tax) law, a separate legal entity exists.
Although a private letter ruling is only binding with respect to the specific taxpayer to whom it is issued, private letter rulings reflect the view of the IRS and are commonly used for planning and taxpayer interpretation of the applicable tax law. Each corporate group utilizing the friendly PC model should evaluate the potential application and impact of consolidated tax return PC inclusion on a state-by-state basis. If it is determined that such beneficial ownership is permitted under the applicable state laws and doctrines, the Manager must decide whether it is desirable to structure for the PC’s inclusion in the consolidated return or structure for exclusion.
If a consolidated tax return is filed by the Manager’s corporate group, the tax rules require all “includible corporations” (such as the PCs in the PLR) be included in the consolidated tax return. Affiliated groups filing consolidated returns are not permitted to pick and choose which includible corporations are reported in the consolidated tax return. Given the variation in state corporate practice doctrines and laws and the business terms of the contractual arrangements, a Manager serving a large number of PCs may have some PCs that are “includible corporations” and others that are not. Assuming state corporate practice laws permit and will enforce a stock transfer agreement and related agreements as described in the PLR, affirmative steps can be taken to cause the relationship between the PC and the Manager to either constitute or not to constitute beneficial ownership of the PC’s stock under the PLR.
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