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Professional Corporations:
To Be or Not to Be a
Member of a Consolidated Group
Many independent
professional medical and dental practices are incorporated under state law as
professional corporations (PCs). Generally, these state laws require that PCs
issue shares only to individuals who are duly licensed or otherwise legally
authorized to render the same type of professional services as those for which
the PC was organized. Thus, entities other than individuals (corporations,
partnerships, etc.) are not authorized by law to own such stock.
Overview Frequently,
a licensed individual practitioner (employee) legally owning PC stock enters
into a contractual agreement with a management company engaged in the business
of providing administrative, financial, marketing and other non-healthcare
personnel, facilities and equipment to independent professional medical
practices. Typically, these agreements severely restrict the employee’s rights
as a stockholder. For example, the agreement may require the employee to vote
the stock of the PC and elect the board of directors in accordance with the
management company’s recommendation. In addition, the employee may not be
entitled to any dividends or capital appreciation on the PC’s stock, nor be
liable if it declines in value. Further, the agreement may provide the
management company with the option to purchase the employee’s PC stock (at any
time) through another licensed individual under its employment for the initial
nominal capital originally contributed by the employee for the PC stock. If
the management company holding all these important rights is itself a
corporation that joins in a consolidated Federal income tax return, does the PC
thus become a member of that group?
Code and Case Law Sec.
1504 provides two general requirements for filing a consolidated return. First,
each corporation seeking to file must be classified as an “includible”
corporation as defined by exclusion under Sec. 1504(b). A PC is not among the per se nonincludible
corporations listed in Sec. 1504(b), so the analysis moves to the second
requirement. To
be part of an affiliated group, the stock of each includible corporation must
meet certain ownership tests. Sec. 1504(a) defines an affiliated group as one
or more chains of includible corporations connected through stock ownership
with a common parent that is an includible corporation, but only if said parent
directly owns stock meeting the
requirements of Sec. 1504(a)(2) in at least one of the
other includible
corporations, and stock meeting those requirements in each of the includible
corporations (except the common parent) is owned directly by one or more of the other includible corporations. For
this purpose, stock ownership of any corporation meets the requirements for
affiliation if it possesses at least 80% of the total voting power and at least
80% of the total value of such corporation’s stock. Given
the typical state law governing PCs, the management company in the scenario
discussed above would not appear to own directly the PC’s stock. However, the
IRS and courts have interpreted Sec. 1504(a)’s direct-ownership requirement to
mean “beneficial ownership” of stock, not legal ownership. This interpretation
of direct ownership recognizes that substance, rather than form, should
control. In Macon, Dublin & Savannah
Railroad Co., 40 BTA 1266 (1939), the court stated that “direct ownership
required by the statute is not merely possession of the naked legal title, but
beneficial ownership, which carries with it dominion over the property.” This
conclusion followed Corliss v. Bowers, 281 US 376 (1930), in which
the Supreme Court stated that “taxation is not so much concerned with the
refinements of title as it is with actual command over the property taxed.” In
Miami National Bank, 67 TC 793
(1977), the Tax Court held that a shareholder retained beneficial ownership of
stock, even though the stock had been transferred to a subordinated securities
account in which the securities broker possessed legal title and could sell it
to satisfy creditors’ claims. The shareholder retained significant incidents of
ownership, including the right to receive dividends, vote the stock and assign
his or her interest in it. While such account was in effect, the shareholder
and other holders of such stock agreed to sell over 80% of it to a third-party
corporation. Although the shares were not immediately transferred and instead
were temporarily maintained in the securities account, the court ruled that, on
the date the purchase agreement was signed, the purchasing third party
“directly owned” the stock for Sec. 1504(a) purposes, such that the two
corporations could file a consolidated return.
IRS Rulings Rev. Rul.
84-79:
The Service’s view is consistent with the courts’. For example, in Rev. Rul. 84-79, P Corp. wholly owns the stock of subsidiary S
Corp., which owns an aircraft it intends to register with the Federal Aviation
Administration (FAA). Under FAA regulations, 75% of the voting interest of a
corporation wishing to register its aircraft with the FAA must be owned or
controlled by In
concluding that P directly owned the stock for Sec. 1504(a) purposes, the IRS
cited Miami National Bank for the
proposition that legal title alone does not constitute direct ownership and
further concluded that possession of “everything but legal title” equals direct
ownership. Letter
Ruling 9605015:
In Letter Ruling 9605015, the Service ruled on facts similar to the
medical/dental practice scenario previously discussed. To comply with the
relevant provisions of state X’s PC law, Parent acquired several primary-care
medical practices using an acquisition strategy in which loans were made to a
physician-employee (employee) to set up a PC (New PC), acquire the intangible
assets of a targeted medical practice (Old PC), employ the physicians selling
the practice and provide medical care. A management services company owned by a
subsidiary of Parent (Acquiring) then acquired the tangible assets of Old PC
and provided various management and administrative services to New PC. As
part of the transaction, the employee entered into a pledge agreement severely
restricting his rights. He was required to vote the New PC stock in accordance
with Acquiring’s recommendation and was directed by
Acquiring as to New PC’s board of directors and officers. In addition, the
employee was not entitled to any dividends or capital appreciation in New PC’s
stock. The IRS ruled that the employee’s stock ownership constituted beneficial ownership to
Acquiring and, thus, was direct ownership for Sec. 1504(a) purposes. The
Service subsequently changed its conclusion (see Letter Ruling 9752025,
retroactively revoking Letter Ruling 9605015). In the later ruling, it provided
no explanation as to why its earlier ruling was inappropriate. However, Field
Service Advisory (FSA) 199926014 provides useful insight. FSA
199926014:
The FSA addresses whether the pertinent provision of state X bars beneficial
ownership of PC stock by a shareholder other than a licensed individual. In its
analysis of the legal principles, the Service respects Rev. Rul.
84-79, as well as the findings in the cases discussed above. Nevertheless, the
FSA concludes that Parent cannot be considered the beneficial owner of the New
PC stock under state law and, thus, cannot be deemed the direct owner of the
New PC stock for Sec. 1504(a) purposes. The FSA cites an unnamed provision of
state X law (§y) that precludes not only legal, but also beneficial, ownership
of a professional corporation by anyone other than a licensed individual. Thus,
any attempt by Parent to claim the benefits and assign itself the burdens of
owning the New PC stock does not override §y. In addition, §y provides that any
transfer of the beneficial ownership of a professional corporation’s stock to
someone other than another licensed individual is void. Accordingly, the FSA
concludes that Parent cannot be considered the beneficial owner of the New PC
stock and, thus, cannot be deemed the direct owner of the New PC stock for Sec.
1504(a) purposes.
Conclusion In
contemplating whether a PC can be included in a consolidated group for Federal
income tax purposes, several key issues should be considered. First, any agreements
entered into by the employee-shareholder owning the legal title in the stock,
with another corporation, should be examined to determine if restrictions have
been placed on the shareholder’s rights that may convey beneficial stock
ownership to the corporation. Second, the PC law in the state in which it was
incorporated should be reviewed to determine whether any language specifically
(1) prevents beneficial ownership of a PC by anyone other than a licensed
individual or (2) provides that any transfer of beneficial ownership of a PC to
someone other than another licensed individual is void. In the case of a
medical management company holding agreements with several PCs located in
various states, it is quite possible that differences in states’ PC laws could
result in some PCs being considered for inclusion in the consolidated group and
others being left to file separately. Given
the possibility that a PC may be eligible to join in the filing of a
consolidated return, several other interesting collateral questions arise. For
example, if PC ownership meets the Sec. 1504(a) affiliated-group requirements,
would it be possible to liquidate the PC tax free under Sec. 332 or claim a
worthless stock deduction as to its stock, under Sec. 165(g)(3), to obtain
ordinary loss treatment? Could the PC’s business be considered under the
“affiliated group rule” in assessing whether the active-trade-or-business
requirement under Sec. 355(b) has been met? These and other issues could arise
from the beneficial ownership of sufficient PC stock.
From Jay R. Shallenberger, CPA, |
