With the significant uptick in mergers and acquisitions (M&A) activity in professional fields such as medicine, due primarily to an influx of private equity (PE) capital, the question of tax ownership of the professional practice has become a significant issue. M&A activity involving professional firms also raises significant questions as to the availability of tax favorable treatment under the section 199A qualified business deduction and the section 1202 gain exclusion on qualified small business stock.
So why does this issue arise?
In most industries, when a purchaser desires to acquire a target business from its owners, the parties structure an M&A transaction involving the acquisition of either the target’s business assets or its equity. While complexities arise in many transactions, the question of ownership of the business after the transaction is generally not in question.
However, in the case of professional practices such as medicine, state law often limits ownership of a professional corporation (PC) or professional LLC to a licensed practicing professional. Therefore, to accomplish the transaction, the parties often enter into a number of agreements governed by an overall master service agreement (MSA) between the professionals and a master service organization (MSO or management company), generally owned by the PE. In the context of medical practices, this is often called the “friendly physician arrangement.” Where the PC is an S corporation, the transaction is often structured as an asset acquisition by the MSO of certain nonclinical assets, including the goodwill and all intangible assets of the PC, along with the execution of the MSA.
Under the typical MSA and supporting agreements, while the professionals retain legal title to the PC, essentially all economic benefit and voting control is transferred to the MSO. In most situations the MSA and related agreements will include provisions designed to transfer the benefits and burdens of ownership and voting in varying degrees, such as:
- A “lock-box” bank account that holds all cash receipts of the PC that the MSO controls, thereby eliminating the ability of the PC to declare dividends or utilize cash for reasons outside those specified in the agreement.
- The shareholders of the PC are prohibited from disposing of shares or liquidating or dissolving the PC without MSO consent, and are required to transfer shares (or are deemed to transfer even if the shares are not actually transferred) to a new professional for minimal consideration.
- Option agreements requiring the PC's shareholders to sell the shares to the MSO for minimal consideration immediately before the sale.
- The MSO manages all aspects of the business, with the exception of specified professional decisions (e.g., medical decisions).
- A non-arm’s length management agreement that is structured to appear based upon specific criteria but includes provisions allowing the MSO to unilaterally change the terms to reflect the fair market value of the services or current market conditions. The result is that the management fee is adjusted ensuring the full transfer of economic benefits to the MSO.
- Agreements allowing the MSO to replace a board director without cause.
As discussed in more detail below, because mere retention of legal title to property does not represent ownership for tax purposes, does the tax law respect the legal status of the PC as an entity owned by the professionals and not by the MSO?
This question has many ramifications, including the following:
- If the MSO is part of a consolidated group, must the PC join that consolidated group?
- If the MSO is not part of a consolidated group, should the PC operate to a breakeven to account for the economic reality of the MSA arrangement?
- If the PC is an S corporation, and the MSO is ineligible to own an S corporation (e.g., It is a C corporation), will the MSA cause a revocation of the S corporation status?
- If the PC is an S corporation and sells assets concurrent with entering into the MSA, did the PC's S status terminate the day before the asset sale, in which case, the asset sale occurred while the PC was a C corporation?
- If the PC is a C corporation with net operating losses (NOLs), will the MSA arrangement create an ownership change with a resulting section 382 loss limitation?
- If the PC is organized as an LLC and files as a partnership before entering into the MSA, should the PC now be treated as a disregarded entity of the MSO and desist from filing?
- Could entering into an MSA result in a qualified stock purchase, thus enabling a section 338(h)(10) or section 336(e) election?
Additionally, the determination of ownership of the PC can affect treatment under sections 199A and 1202. Section 199A grants noncorporate taxpayers a 20 percent deduction on qualified business income, while section 1202 grants noncorporate taxpayers a 100 percent exclusion for the gain from the sale of stock of qualified small businesses purchased at its original insurance and held by the taxpayer for more than five years. Under both provisions, professional services businesses are generally not qualifying businesses-- income from such a business does not qualify for the section 199A deduction, and the sale of stock of a corporation engaged in such a business does not qualify for the section 1202 exclusion.
Accordingly, if the MSO is an LLC taxed as a partnership and is treated as owning the PC, the owners of the MSO may not be entitled to a section 199A deduction either because the PC would become a disregarded entity of the MSO, or if the PC is a corporation, because the management fees earned by the MSO are a mechanism to transfer the benefits of ownership (i.e., profits) from the PC business, which is derived from nonqualified specified services income. Additionally, where the MSO acquired the goodwill and intangibles of the PC, the management fees may represent payment for the use of intangibles in a nonqualified specified service business, thereby tainting the management fee income as a specified service. Lastly, the MSO itself may include disqualifying features, such as the MSO’s direct employment of nurses.
A similar analysis pertains to the section 1202 exclusion. If the MSO is a corporation and is treated as owning the PC, the shareholders of the MSO likely are not entitled to the section 1202 exclusion, as the PC’s income is derived from nonqualified specified services income. See section 1202(e)(5). Even if the PC is treated as owned by the professionals, depending on the nature of the MSA, sale of the MSO stock may be ineligible for the exclusion because, as discussed immediately above, the business that generated the MSO’s income is that of the ineligible PC.
The question as to the tax ownership of a PC is just one example within the tax law where ownership of property is not based merely on title but rather on the benefits and burdens of ownership. For example, questions as to ownership often arise in the context of sale-leaseback and similar financing transactions.
In general, the substance over form doctrine dictates that in determining ownership the tax law looks to the benefits and burdens of ownership rather than to mere state law legal title. “It is well settled that the economic substance of transactions, rather than their form, governs for tax purposes”; tax law thus looks to whether a transaction involved a “transfer of benefits and burdens.” Grodt & McKay Realty, Inc. v Commissioner, 77 T.C. 1221 (1981), citing Gregory v. Helvering, 293 U.S. 465 (1935). The tax law “is not so much concerned with the refinement of title as it is with actual command over the property taxed,” Corliss v Bowers 281 US 376 (1930); thus, “[p]ossession of everything but legal title is the equivalent of direct ownership.” Miami National Bank v Comm’r, 67 T.C. 793 (1977).
In the context of the consolidated group rules, the ownership requirement of section 1504(a) has been interpreted to mean the benefits and burdens of ownership notwithstanding a lack of title to the property. See id; Rev. Rul. 84-79. In other contexts as well, ownership has been interpreted to refer to the benefits and burdens of ownership. See, e.g., Grodt, 77 T.C. 1221 (1981). As the Tax Court stated: “When deciding whether a deal is a sale, we ask whether the benefits and burdens of property ownership have passed .... This is a question of fact determined by examining the written agreements and all the relevant facts and circumstances.... We do not require “the technical requirements for the passage of title under state law to be satisfied.” Gaggero, TC Memo 2012-331 (2012). The Tax Court’s list of indicia of ownership includes:
- whether legal title passed;
- the manner in which the parties treated the transaction;
- whether the buyer acquired an equity interest in the property;
- whether the buyer has any control over the property and if so, the extent of such control;
- whether the buyer bore the risk of loss or damage to the property;
- whether the buyer received any benefit from the operation or sale of the property;
- whether the contract obligated the seller to execute and deliver a deed and the buyer to make payments; and
- whether the buyer had a right to possess the property or an obligation to pay property taxes.
Id.; Grodt, 77 T.C. 1221 (1981).
In various scenarios that bear some similarities to MSAs, the IRS placed the focus of ownership on benefits and burdens of ownership beyond mere title. For example, in Rev. Rul. 55-458, a shareholder transferred legal title in shares to an escrow agent to secure the shareholder’s remaining obligation for the purchase price of the shares while retaining voting and dividends rights except in case of default; the IRS ruled that the shareholder retained ownership. In Rev. Rul. 70-469, a shareholder transferred legal title in shares to a nominee in order to qualify the nominee as a director, but the nominee was at all times legally obligated to deal with the shares according to the parent's orders; the IRS ruled here as well that the shareholder and not the nominee retained ownership. Similarly, in Rev. Rul. 84-79, a parent corporation transferred legal title of its subsidiary stock to a voting trust but retained the benefits and burdens of ownership; the IRS ruled here as well that the parent retained section 1504(a)(2) ownership.
Note, however, that the correct result is highly fact-specific. For example, in one case, a corporation acquired irrevocable proxies to vote 80 percent of a second corporation’s shares, based upon which the first corporation included the second corporation in its consolidated group. The IRS rejected this treatment, and said that the mere right to vote is insufficient for a nontitleholder to meet the voting power requirement of section 1504(a)(2); obtaining the benefits and burdens of ownership requires indicia of ownership beyond the “bare right to vote.” Field Service Advice 1993-725.
The IRS considered the friendly physician arrangement several years ago in Priv. Ltr. Rul. 201451009. In that case, a consolidated group member entity entered into agreements with the shareholder of two PCs. The agreements included various restrictive clauses, including that: (i) the entity performed all nonprofessional administrative and managerial services, while the shareholder served as the director and held legal title to the shares; (ii) the shareholder was prohibited from transferring the shares; (iii) the shareholder was prohibited from having the PCs pay a dividend or issue additional equity interests, (iv) the shareholder was prohibited from consenting to a liquidation or dissolution of the PCs without the prior consent of the entity; and (v) upon the occurrence of certain events, the PCs would transfer all of the shares to someone identified by the entity. Thus, although legal title to the stock remained with the PC shareholder, the benefits and burdens of ownership, including voting control, were transferred to the consolidated group member.
Under these facts, the IRS ruled that the PCs were members of the consolidated group and could join in the filing of its consolidated federal income tax return. (This ruling stands in contrast with a ruling from 1997 rejecting such treatment under similar circumstances; see Priv. Ltr. Rul. 9752025; F.S.A. 199926014.)
Accordingly, when evaluating whether an MSA should be treated as a transfer of to the MSO, practitioners should not merely focus on legal title, but must carefully consider whether the benefits and buderns of ownership have been transferred. The practitioner should look to more than the purchase agreement, but should focus on the MSA and related agreements, and to the substance of the transaction as opposed to the form. Common clauses in MSAs that should be scrutinized include:
- How much did the MSO pay for the benefits it received? Is the amount disproportionate to the amount that would be expected to be paid for a typical management service agreement? The arrangement may intend to include a non-arm’s length management fee, as the upfront payment by the MSO to the PC is often intended to transfer the full benefits and burdens of the practice.
- Is the management fee adjustable whenever necessary to “reflect the value of services” provided? This may be a mechanism to move all benefits and burdens to the MSO.
- Does the MSO have the right to cause the transfer of the PC shares to another professional for minimal consideration?
- Do the PC’s shareholders and board of directors have the right to pay dividends, dissolve, liquidate or sell without MSO approval?
- Does the MSO have the right to replace the board of directors or medical director with any other professional it wishes to appoint?
- Does the MSO have the power of attorney over a cash lock box?
- Does the MSO have the right to require a sale of the PC to the MSO for minimal consideration?
Note that a tax result that treats the PC as a subsidiary of the MSO does not necessarily dictate the treatment of the PC for regulatory purposes. Nonetheless, regulatory attorneys may argue against inclusion of the PC on the MSO’s consolidated return because they are concerned that such inclusion weakens the position they took for nontax state law purposes. Notwithstanding such claims, tax practitioners must focus on the tax rules when determining appropriate tax treatment.