HEALTH INDUSTRY ONLINE - IRS Ruling Holds Interest Payments from Controlled Physician Organizations to be Unrelated Business Taxable Income

IRS Ruling Holds Interest Payments from Controlled Physician Organizations to be Unrelated Business Taxable Income

In April of this year, the IRS released Private Letter Ruling 200716034 (Jan. 26, 2007) that may impact the tax treatment of certain payments between component entities of integrated health care delivery systems. This ruling, which appears to be a departure from previous IRS positions, held that interest payments received by a tax-exempt hospital and the tax-exempt parent of an integrated delivery system from taxable physician corporations controlled by the Hospital constituted unrelated business taxable income ("UBTI") under Internal Revenue Code ("Code) section 512(b)(13)(A). The IRS based its holding on its conclusion that patients of the controlled physician corporations are not patients of the hospital.

PLR 200716034's facts involved a hospital ("Hospital") exempt from federal income tax as an organization described in Code section 501(c)(3), the integrated delivery system's parent entity ("Parent"), also exempt from federal income tax under 501(c)(3), and several taxable professional medical corporations ("PCs") some of which were S corporations.¹ The stock in each of these PCs was wholly owned by individual physicians; however, the Hospital, the PCs, and the individual physicians had employment agreements, shareholder agreements, and affiliation agreements in place governing the rights of the parties in connection with the PCs' stock.

The employment agreements provided that physicians were to be employed as chairmen of the hospital's separate departments, and the affiliation agreements obligated the hospital to provide management, professional, and administrative services to the PCs. Under the shareholder agreements, the physicians acquired the PCs' stock for a nominal amount, were required to be employed by the hospital through the PCs, and were prohibited from selling, assigning, transferring, encumbering or disposing of their PC stock. Should a physician's employment with the PC terminate, the shareholder agreement required the physician to sell all PC shares to an individual selected by the Hospital for the same nominal value the physician originally paid.

The acquisition, operation, and formation of each of the PCs were funded primarily through loans from the Parent and the Hospital. Payments on these loans were infrequent, but both the Hospital and the Parent accrued the unpaid interest. The central issue in this ruling was whether this interest constituted UBTI pursuant to Code section 512(b)(13).

Code section 512(b)(13)(A) provides that a "specified payment" received or accrued by a tax-exempt organization from a "controlled organization" is treated by the controlling organization as UBTI to the extent it reduces the "net unrelated income" of the controlled organization. Per Code section 512(b)(13)(C), specified payments mean any interest, annuity, royalty, or rent. Code section 512(b)(13)(B)(i)(I) defines the term net unrelated income in the case of a controlled entity not exempt under Code section 501(c)(3) to be the portion of the entity's taxable income which would be UBTI if such entity were tax-exempt having the same exempt purpose as the controlling organization. Control is defined in the context of a corporation in Code section 512(b)(13)(D)(i) as ownership by vote or value of more than fifty percent of a corporation's stock.

The IRS stated that, although the PC's shares were legally owned by the individual physicians, under the shareholder agreements the Hospital held all significant rights granted by stock ownership. Thus, the IRS concluded the Hospital was the beneficial owner of the PCs' stock. The IRS then held that since the Hospital beneficially owns by vote more than fifty percent of the PCs' stock, it was a controlling organization of the PCs within the meaning of section 512(b)(13)(A) of the Code.

As to whether any interest paid to or accrued by the Hospital or the Parent would reduce the net unrelated income of the PCs, first the IRS held the PCs providing services to "their own patients" [emphasis added] does not have a substantial causal relationship to the achievement of the hospital's exempt purposes. Thus, if the PCs were exempt from tax having the Hospital's tax-exempt purpose, the income the PCs generate from treating their own patients would be UBTI because the PCs patients are not also considered patients of the Hospital. Second, the IRS held that receipt by the Hospital or Parent of the interest payments, which are specified payments under Code section 512(b)(13)(C), would be UBTI to the extent such payments reduce the PCs net unrelated income or loss. Since the PCs were held by the IRS to be engaged in an unrelated trade or business with respect to the Hospital, any interest payment would seemingly reduce the PCs' net unrelated income and be reportable as UBTI by the Hospital and the Parent.

PLR 200716034 appears to signal a departure from the IRS's previous definition of patient which would have been broad enough to consider patients of the PCs to also be patients of the Hospital. Based on this narrowing of how the IRS defines patients in the context of integrated healthcare delivery systems, such organizations should examine specified payments between their component entities to determine if there is possible exposure to UBTI.