Losses may no longer be held captive in captive PCs

March 09, 2015

Health Care Alert

Author(s): Kenneth H. Silverberg, Bryan R. Denberg, Jill H. Gordon, Michele A. Masucci, Valerie Breslin Montague, Julie K. Seymour, Michael I. Schnipper

The IRS recently released a private letter ruling that provides guidance to management service organizations, hospitals and other entities that utilize the captive business model. What does your company need to know?

Hospitals, management service organizations and other entities that utilize captive professional corporations to engage in physician practice acquisitions or physician employment in states that prohibit the corporate practice of medicine may gain significant tax benefits from private letter ruling (PLR) 201451009, released by the Internal Revenue Service on December 19, 2014 (the “PLR”).

The PLR held that a for-profit practice management company (the “Management Company”) and its two “captive” professional corporations (each a “PC” and together, the “Captive”), each of which are organized in different states, and both of which are organized in different states from the Management Company, may file a consolidated federal income tax return as members of an “affiliated group” under Internal Revenue Code Section 1504(a).

Under the facts of the PLR, the Management Company did not own any equity shares in the Captive. Instead, the Captive was wholly owned by a professional shareholder (the “Shareholder”) authorized and licensed in the states in which each PC was organized, respectively, to engage in the profession for which the Captive was organized. However, three notable contractual arrangements existed among the Management Company, each of the PCs and the Shareholder:

  1. First, under the terms of support services agreements between the Management Company and each of the PCs respectively, the Management Company performed all administrative and support services on behalf of the Captive, including financial reporting, billing and information systems support, in exchange for a fee. The Management Company managed the Captive to the extent such activities did not involve engaging in the profession for which the Captive was organized.
  2. In addition, the Shareholder and the Management Company were parties to a certain Director Agreement pursuant to which the Shareholder served as Professional Director of each PC and oversaw and coordinated the business objectives of each PC. The Management Company had the power to terminate the Director Agreement without cause or penalty.
  3. Lastly, the Management Company, the Shareholder and each PC were parties to Stock Transfer Restriction Agreements. The Stock Transfer Restriction Agreements gave the Management Company:
    • control over the Shareholder’s ability to freely transfer the equity stock of the respective PCs;
    • the right to designate the professional shareholder of each PC if the Shareholder was removed due to the occurrence of certain events; and
    • the power to dictate how the Shareholder must vote in certain instances; for example, the Shareholder was prohibited from voting, either as a shareholder or director of the Captive, (i) to issue more of each PC’s stock to any individual, entity or firm; (ii) to amend or otherwise attempt to amend either of the PC’s articles of incorporation or bylaws; (iii) to declare a dividend on either of the PC’s shares; or (iv) in favor of a merger, dissolution of the assets of either PC, or a transaction resulting in the sale, mortgage, lease or other disposition of all or substantially all of the either PC’s property or assets.

Specifically, the IRS ruled that the Management Company was the “beneficial owner” of the Captive because of, among other things, the Management Company’s effective control over the Captive under the terms of the Stock Transfer Restriction Agreements. Since the Management Company was the beneficial owner of the Captive, the IRS concluded that the Captive could be included as part of the Management Company’s affiliated group (within the meaning of Section 1504(a)(1) of the Internal Revenue Code) for federal income tax purposes.

The PLR is important for any business group that uses the captive business model, which is often employed by entities to comply with the corporate practice of medicine (CPOM) doctrines that exist in many states. Generally, a state’s CPOM doctrine prohibits business corporations from practicing medicine or employing a physician to provide medical services in that state. In response to CPOM doctrines, business corporations sometimes form professional corporations, which in turn employ or contract with licensed professionals to provide the professional services in the applicable state.

State laws governing professional corporations typically allow only professionals licensed in that particular state to own shares in a professional corporation and serve on its board of directors. Consequently, business corporations select a friendly licensed professional to serve as the shareholder and director of the professional corporation. The presence of the friendly licensed professional permits the business corporation to control the professional corporation by way of certain agreements among the business corporation, the professional corporation and the licensed shareholder.

Under this structure, the professional corporation provides the professional services and the business corporation provides management and other administrative services on behalf of the professional corporation, in exchange for a fee. It is important to note that not all states prohibit the corporate practice of medicine. In states that do prohibit the corporate practice of medicine, it is imperative that the relevant rules, regulations, case law and guidance be reviewed carefully to ensure that the captive model employed does not violate the corporate practice prohibition. To the extent that certain elements from the facts disclosed in the PLR are not permitted in a state, it may become difficult to apply the ruling from the PLR, as the analysis for an “affiliated group” is a facts and circumstances analysis. It should be pointed out that certain terms of the Stock Transfer Restriction Agreements in the PLR, which prohibited the Shareholder from freely voting his shares in the PCs under specific scenarios, may violate the CPOM doctrine of some states.

Significant federal tax benefits are afforded to business groups which file consolidated federal income tax returns as members of an “affiliated group.” Examples of potential benefits include the ability to consolidate tax returns, to offset gains in one entity of an “affiliated group” against losses from another and the ability to transfer assets among the members of the “affiliated group” on a tax-free basis. As a result of the PLR, business groups which make use of the captive structure may be able to take advantage of such benefits.

Note that the PLR was issued to a for-profit management services organization and may only be relied upon by the entity that requested the ruling. However, the PLR does provide insight and guidance on the IRS’s general position regarding inclusion of a captive professional corporation as a member of an “affiliated group.” Therefore, the PLR can be useful to nonprofit entities, which often establish captive professional corporations as well.

While a professional corporation owned by a private individual typically would not meet the IRS requirements for tax-exempt status, it may be possible for a captive professional corporation of a tax-exempt entity to obtain federal income tax exemption in limited circumstances. In particular, in 2000, the IRS promulgated unofficial guidance addressing how to structure a captive professional corporation as an exempt organization. This guidance is limited to states whose CPOM doctrine prevents hospitals from employing physicians who provide outpatient services. Tax-exempt hospitals, and other tax-exempt entities, should carefully analyze both federal and state tax and regulatory law prior to determining whether or not to establish a captive professional corporation.

Hospitals, management service organizations and other entities that utilize the captive business model should consider this PLR and its potential tax benefits.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

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