Cash advances between an MSO and ‘friendly’ PC–What are they?

Executive summary

Professional practices (such as medical practices) that seek investments are often constrained by state regulations that limit the ownership of professional practices to professionals. These practices often enter into management service organization (MSO)-professional corporation (PC) relationships through the mechanism of an MSO which, aside from providing management services, enables the non-professional investors to profit from the practice. For a summary of various tax issues arising from this common business relationship, see our article Who really owns that medical or professional practice?.

As part of this arrangement, the MSO often funds the PC via cash advances, often documented via notes or left undocumented entirely. These advances are generally eliminated in any financial reporting and often do not receive much attention until the amounts become large enough to require attention. However, the status of these advances as debt/liabilities of the PC requires close consideration.

A recent court case highlights the need for taxpayer attention to this matter. In Anaheim Arena Management LLC et al. v. Commissioner; No. 16724-19; T.C. Memo. 2025-68, the Tax Court analyzed in detail cash advances between a management company and an operating company to determine whether the advances were debt or equity. The Tax Court ultimately agreed with the IRS and disallowed the taxpayer’s claimed bad debt deduction. Although the advances were ostensibly documented as debt, the court looked at the substance of the arrangements and concluded they were not debt.

While this case addresses a bad debt deduction specifically, the status of related party advances as debt versus equity is critical to many tax determinations such as tax ownership, deductibility of interest expenses, dividend characterization and withholding taxes. Unlike other IRS wins in which a taxpayer did not altogether document its advances as debt, in this case, the taxpayer attempted to document the intercompany advances through promissory notes that contained interest rates and repayment schedules to ensure compliance with legal standards and proper classification of the advances. The court nonetheless ruled that the advances were not debt.

While Anaheim does not involve an MSO-PC fact pattern, it illustrates the sort of tax analysis applicable to cash advances between an MSO and PC. For prior RSM articles on cases involving cash advances treated as equity and not debt, see Tax Court denies bad debt deduction; advances were equity and not debt; and Tax Court once again denies related party bad debt deduction.

Introduction

As private equity firms and other non-professional investors continue to expand their presence into professional service companies such as healthcare companies, the use of MSO-PC structures continues to be a key avenue used to navigate regulatory restrictions. These arrangements, while offering operational and regulatory flexibility, introduce complex tax considerations. One such area of complexity relates to the classification of advances between the MSO and PC. A recent Tax Court ruling highlights the risks of relying on promissory notes to support debt treatment of related party advances.

The AAM case involved an arena management company which managed the Honda Center on behalf of the City of Anaheim. As part of its management responsibilities, AAM was authorized to pay operating expenses on behalf of the City, and was entitled to repayment of its cash advances plus a portion of the residual profits of the Honda Center. The cash advances were documented in promissory notes; however, the notes were not signed by the City, only by AAM and the Honda Center.

During the 15 years that AAM serviced the Honda Center, AAM (which managed the Honda Center’s bank accounts) documented the advances and then repaid itself the principal and interest to the extent funds were available. Ultimately, AAM concluded that a portion of the advances would not be repaid and therefore claimed a bad debt deduction of more than $50 million.

Holding

The court determined that the intercompany advances made by AAM were not bona fide debt. This classification is crucial because only bona fide debt qualifies for a bad debt deduction. Since the advances were not considered bona fide debt, AAM was not entitled to claim a bad debt deduction for the amounts in question.

Case law factors for debt versus equity

The court analyzed and applied various debt-equity factors to determine whether the advances constituted bona fide debt, including:

1. Intent of the parties: Whether there is a genuine intention to create a debtor-creditor relationship.
2. Documentation and formalities: The presence of formal loan agreements, promissory notes and repayment schedules.
3. Thin capitalization: Whether the company has sufficient capital to support the debt load.
4. Interest payments: Whether interest is charged and paid on the advances.
5. Repayment terms: The existence of a fixed repayment schedule.
6. Subordination to other debt: Whether the advances are subordinated to other debts.
7. Ability to repay: The borrower's ability to repay the advances from operating funds.
8. Ability to obtain third-party financing: Whether the borrower could obtain external financing.
9. Identity of interest: Whether the purported borrower is also an owner of the company.
10. Participation in management: Whether the lender is actively engaged in the management of the business.

The court concluded that these factors indicated that the advances did not constitute debt for tax purposes, despite the fact that AAM attempted to document the advances via promissory notes.

This case involved a partnership, so section 385(c) did not apply to the situation. Section 385(c), in some cases, forces reclassification of debt in a corporation as stock of the corporation, but section 385(c) is not applicable to partnerships.