In PLR 202049002 (Dec. 4, 2020) the IRS ruled, in line with a 2014 Private Letter Ruling, that entering into a management service agreement (MSA) between a Professional Corporation (PC) owned by a professional and a management service organization (MSO) can result in transfer of ownership in the PC for tax purposes, despite the retention of legal ownership by the professional.
Introduction to the issue
In most industries, when a buyer desires to acquire a target business, the buyer purchases the target stock or assets outright. However, in the case of professional practices such as medicine, state law often limits ownership of a PC to a licensed practicing professional. If the buyer cannot legally own the business under applicable state rules, the PC and an MSO entity owned by the buyer often enter into an MSA to achieve the desired economics. Under many of the MSA arrangements, while the professionals retain legal title to the PC, economic benefit and voting control is transferred to the MSO. In the context of medical practices, this is known as the “friendly doctor arrangement.”
As discussed previously in our article Who really owns that medical or professional practice?, mere retention of legal title to property does not represent ownership for tax purposes. As a result, the owner of property (e.g. stock in the PC) for tax purposes can be different than the owner for legal purposes. In essence, whether an MSA transfers ownership to the MSO does not depend on legal title, but turns on whether the benefits and burdens of ownership have been transferred (beneficial ownership).
The PLR
In PLR 202049002, Parent and Sub were, respectively, the parent and member of a consolidated group, and Sub owned an MSO, an LLC. While the MSO performed all administrative and support services on behalf of PC, a Professional Corporation, the PC’s shareholder retained legal title to the PC shares. The MSA between the parties transferred the PC’s voting control and all economic benefit to MSO.
The MSO and the PC entered into agreements that included the following provisions:
- The PC shareholder was prohibited from transferring any shares of the PC stock, and if he were to do so, the stock would automatically transfer to a transferee designated by Parent for a nominal cost.
- The PC shareholder was prohibited from declaring a distribution with respect to the PC stock or from issuing additional equity interests.
Parent made several representations, including that:
- The legal arrangements were legally valid and enforceable.
- Applicable state law only prohibited the Sub from practicing the PC profession, controlling the PC’s professional decisions, and from legally owning the PC stock, but did not prohibit Sub from beneficially owning the PC stock.
Based on these facts and representations, the IRS ruled that the PC was owned by Sub. The PC was therefore a member of the Parent-Sub consolidated group.
Observations
The conclusion reached in this PLR is based upon well-established principles of tax law developed over decades, which conclude that ownership for tax purposes is determined based upon all facts and circumstances, and not legal title to the property. Also important to note is that while the PLR involved a question of filing a consolidated tax return, the question of whether the agreements between the parties transferred ownership has far-reaching effects beyond the consolidated return context. Whether to file a consolidated return is elective, whereas determining whether a transaction transferred ownership of an entity is not elective.
The inclusion by the PLR of a representation that, under the facts at hand, state law did not prohibit beneficial ownership appears based upon FSA 199926014 (July 2, 1999) where state law apparently both restricted the transfer of beneficial ownership and would nullify the transaction. While taxpayers entering into similar transactions need to consult with legal counsel, we understand that very few states restrict the transfer of beneficial ownership.
Takeaway
Friendly doctor and similar arrangements crafted to transfer economic ownership of a PC to an acquiring MSO via an MSA deserve scrutiny to determine tax ownership. Legal title to the shares of the PC is but a single, and not persuasive, factor. Decades of case law and rulings surrounding ownership for tax purposes dictate that all facts and circumstances as to which party holds the benefits and burdens of ownership control.
