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According to a private letter ruling released by the Internal Revenue Service (IRS) on April 20, 2007 (P.L.R. 200716034), income generated by professional corporations (PCs) affiliated and funded by a nonprofit hospital and nonprofit parent corporation is unrelated business income under Section 512(b)(13)(B) of the Tax Code, and therefore taxable as gross income to the hospital. The ruling calls into question the benefits of the practice of establishing captive PCs to further tax-exempt hospital’s charitable purposes. Issues and Background Facts In the private letter ruling (PLR), the IRS addressed the following three requested rulings: Were the hospital or parent, based on the facts provided, a “controlling organization” of the PCs under Section 512(b)(13)(A)? If the first issue was answered in the affirmative, did the PCs have net unrelated income or loss under Section 512(b)(13)(B)? If the first two issues were answered in the affirmative, is the interest received or accrued on the loans and advances by the hospital and parent to the PCs taxable as gross income from an unrelated trade or business under Section 512(b)(13)(A)? Under the facts provided, the hospital is a Section 501(c)(3) tax-exempt nonprofit corporation that is part of a large health care system governed by the parent corporation. The parent is a Section 501(c)(3) nonprofit corporation controlling a large health care system that is comprised of both tax-exempt and for-profit taxable organizations. A number of private practice medicine PCs are affiliated with the parent. The PCs’ acquisition, formation and operation were funded primarily through loans and advances from the hospital and parent. Most of these loans and advances were made without written loan agreements or notes. The PCs have paid back principal and interest of the loans infrequently. Accrued and unpaid interest is added back to the substantial outstanding balance of the debt owed to hospital and parent. There were six PCs considered by the IRS in the ruling. They practiced in the areas of comprehensive health services; surgical and musculoskeletal services; cardiovascular and thoracic surgery; radiology; family medicine; and pediatrics. Although I must say I find it hard to believe, the PLR said that none of the six PCs had patients that were also patients of the hospital. Pursuant to the state law under which the six PCs were organized, a physician has to be the shareholder of a medical practice PC. An employee-physician of the hospital (who is a chairman of one of the hospital’s departments) was the sole shareholder of each of the six PCs. There are a series of employment agreements, shareholder agreements and affiliation agreements entered into by the hospital, PCs and physicians. All the PCs have materially the same set of agreements and arrangements. The basic arrangements are as follows: The hospital provides management, professional and administrative services to each PC. Under the shareholder agreements, each shareholder physician purchases the PC stock for a nominal amount. The physician is required to be employed by the hospital through the PC, and the physician is prohibited from selling, assigning, transferring, hypothecating or otherwise disposing of or encumbering the PC stock. Should the physician’s employment with the PC terminate, the physician must sell his or her stock to a hospital-appointed individual for the same amount at which the physician purchased the stock. The physician is not entitled to any of the PC’s profits or losses, and all income from the PC must be given to the hospital. The IRS Analysis In addressing the first requested ruling, Tax Code Section 512(b)(13)(D)(i) provides that “control” for purposes of a corporation means ownership of more than fifty percent of that corporation’s stock. Part (ii) of that same tax code section states that ownership may be constructive. The IRS looked at the case law for who constitutes an “owner” for federal income tax purposes. Citing Frank Lyon Co. v. U.S., the IRS stated that the test of ownership is that of beneficial interest. In this scenario, the IRS said that although the physician employee-owners hold legal title to the PC stock, the hospital is really the beneficial owner because it receives all the significant rights from the stock ownership. Interestingly, despite the IRS’s ruling that the hospital is the true owner of the PC, and the state law requirement that PCs be owned by a physician (therefore rendering the agreements unenforceable), the IRS said that it would still treat the agreements as valid because such treatment accords with business reality. According to the PLR, the agreements should be treated as valid because the parties acted in accord with the agreements; the parties continue to honor the agreements; the hospital and other physicians have honored similar agreements in the past; and there is no economic incentive for the physicians not to honor the agreements. The IRS therefore determined that the hospital is the “controlling organization” of the PCs for tax purposes. Turning to the second requested ruling, the IRS noted that under Tax Code Section 511(a)(1) unrelated business income of a Section 501(c) organization is taxed. Section 513(a) states that “unrelated trade or business” means ” . . . any trade or business the conduct of which is not substantially related . . . to the exercise or performance by such organization of its charitable, education, or other purpose or function constituting the basis for its exemption under section 501 . . . “ The IRS next pointed to the applicable tax code regulations. Under 1.513-1(a), an exempt organization’s gross income is treated as “unrelated business income” if: It is income from a trade or business; Such trade or business is regularly carried on by the organization; and The conduct of the trade or business is not substantially related to the organization’s performance of its exempt functions. Citing next 1.513-1(d)(2), a trade or business will be considered “substantially related” only if the causal relationship is substantial. Here, the IRS said that the PCs’ provision of medical services to their own patients does not have a substantial causal relationship to the hospital’s exempt purposes. Because the PCs are conducting their business on a broader scale than is reasonably necessary for the hospital’s exempt functions, the PCs are engaging in an unrelated trade or business. Therefore, any income or loss (less applicable deductions) from the PCs is “net unrelated income” under Section 512(b)(13)(B) of the tax code. Regarding the last requested ruling, the IRS cited Section 512(b)(13)(C) of the code, which states that “specified payment” means any interest, royalty or rent. Here the IRS pointed to the accrued and received interest on the loans the hospital made to the PCs. The IRS ruled that interest is a “specified payment” under the code and is therefore taxable gross income from an unrelated trade or business. The IRS also made a point to note that no ruling was requested on the applicability of the new Section 512(b)(13)(E) of the code, which was an addition made via the Pension Protection Act of 2006. This section limits Section 512(b)(13)(A) (providing specified payments received or accrued by an exempt organization are treated by the controlling organization as taxable unrelated business income to the extent such payments reduce the net unrelated income of the controlled entity) only to that portion of a specified payment that the controlling organization receives or accrues that exceeds the amount that would meet the requirement of Section 482. This new section applies only to payments made pursuant to a binding written agreement in effect on Aug. 17, 2006 that are received or accrued after Dec. 31, 2005, and on or before Dec. 31, 2007. The IRS declined to rule on it. Private Letter Rulings As the IRS noted in this PLR, the rulings in the letter only apply the exact facts as presented. The rulings do not apply to any other section of the tax code that was not inquired about, and except as expressly requested, no opinion is given on further tax consequences of the transaction. The ruling also only directly applies to the organization that requested it. The tax code provides that it may not be used or cited by others as precedent. Still, letter rulings such as this one give attorneys a clue as to how the IRS is treating sections of the tax code, and how it might look upon similar transactions and helps in planning. In this case, the IRS seemed to hone in on the patients v. non-patients distinction for the PCs vis-�-vis the hospital in determining if the activities of the PCs were an “unrelated” business activity for the hospital. Practitioners should take note that this may be a distinction the IRS continues to look at in assessing future transactions. In most captive PC situations I have seen, the patients of said hospitals and PCs have been substantially the same. VASILIOS J. KALOGREDIS is president and founder of Kalogredis Sansweet Dearden & Burke, a health care law firm, and Professional Practice Consulting Inc., a health care consulting firm, in Wayne, Pa. Among his areas of expertise are group practice arrangements, practice sales and mergers, doctor contract drafting and negotiation, tax and retirement planning for physicians, joint ventures, fraud and abuse matters, and evaluation of practice options for physicians. He can be contacted at 800-688-8314 or by email at [email protected].

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