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Rules Governing Practice before IRS

Entities Engaged in the Corporate Practice of Medicine

Guidelines for analyzing professional service corporation cases involving the Corporate Practice of Medicine (CPOM).

IRC Section and Treas. Regulation

IRC Section 501(c)(3)

IRC Section 502

Treas. Reg. 1.501(c)(3)-1(c)

Treas. Reg. 1.502–1(b)

Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources)

University of Maryland Physicians v. Commissioner, T.C. Memo 1981-23 (1981)

Rev. Rul. 69-545

Rev. Rul. 78-41

Analysis

Corporations that employ physicians to provide medical services are engaged in the corporate practice of medicine.1 Several states restrict the practice of medicine by lay controlled corporations.2 These “CPOM” states

  • do not allow lay controlled corporations to employ physicians to provide medical services3, but
  • do permit Professional Service Corporations -- a special type of corporation which must be owned by physicians -- to do so.

Because the Professional Service Corporation (or “PSC”) is owned by natural persons (“shareholders”), it is normally a taxable corporation, however, the IRS will recognize a PSC as exempt if it meets certain stringent requirements.

Legal Requirements for exemption under IRC Section 501(c)(3).

Like any other applicant, the PSC must meet the organizational and operational tests.

The organizational test requires that a PSC include "organizational language" in an organization's articles of incorporation limiting its purposes to one or more exempt purposes, not expressly empowering it to engage in activities which are not in furtherance of one or more exempt purposes (other than as an insubstantial part of its activities), ensuring that its assets are dedicated to one or more exempt purposes on dissolution, etc. Often, this language appears inconsistent when read in conjunction with the laws created to govern a Professional Corporation formed under a state's business corporation laws. For that reason, the organizational language should not be contrary or incompatible with the language or intent of the statute(s) creating the Professional Corporation. In all states where the IRS has issued determinations, the IRS has received this information.

A PSC has three main hurdles to clear in passing the operational test:

  • The PSC’s activities must be exclusively in furtherance of exempt purposes within Section 501(c)(3).
  • There must be no inurement to stockholders in the form of dividends or profits on transfers of their stock, distributions in the event of dissolution, or excessive compensation.
  • Compensation to the physician employees must be reasonable.

To meet the operational test the PSC must show that it is an integral part of a parent exempt organization.4 An organization is an integral part if it provides services for, or carries on a function for the benefit and convenience of, the parent. Reg. 1.502–1(b). E.g. Rev. Rul. 78-41.

Process requirements for exemption under IRC Section 501(c)(3).

Can there be a parent-subsidiary relationship if the parent does not hold title to the stock of the PSC? There can, and the heart of a CPOM case is a demonstration that the PSC’s physician shareholder or shareholders are subject to stringent restrictions on their activity to the point where a separate 501(c)(3) exempt organization exercises effective control in all respects over the PSC.

The applicant must describe in detail the methods and procedures through which the exempt parent controls the shareholder. The applicant must ensure that the PSC operates in a charitable manner and remains an integral part of the exempt parent holding beneficial title.

The roles played by these agreements may vary from applicant to applicant. For example, some applicants use employment and management agreements instead of shareholder control agreements to bind the physician shareholder to the Parent.

  • Articles of Incorporation and bylaws should contain provisions designed to prevent the shareholder from profiting from stock transactions. State law permitting, the bylaws should vest the right to select directors in the Parent’s Community Board.
  • The Shareholder Control Agreement (SCA) is the fundamental tool for shifting control of the PSC from the shareholder to the Parent. The agreement is an enforceable contract among the PSC, its shareholder and the Parent. Through the SCA, the physician shareholder in effect agrees to hold the stock for the Parent’s benefit, binding itself to the following, or similar, stipulations:
    • The SCA limits shareholder eligibility to licensed physicians, employed by the exempt parent in an administrative capacity, agreeing in writing to become a party to the SCA, or similar agreement binding on the PSC and shareholders.
    • The SCA imposes the provisions of IRC 501(c)(3) on the operation of the PSC.
    • The Parent approves in advance and in writing the voting of every share of the corporation’s stock.
    • The Parent (not the shareholder) initiates all actions regarding the election and removal of the corporation’s board of directors.
    • The Parent selects any transferee of the stock.
    • The SCA prohibits the shareholder from disposing of the stock without the parent’s permission.
    • The Parent limits its stock value to a nominal amount.
    • The SCA binds future transferees of PSC’s shares.
  • A Management Services Agreement (MSA) is another way to vest control of the PSC in the Parent. Under the MSA, the exempt Parent provides management services to the PSC. Agreement of the PSC and the shareholder to the following terms indicates that the PSC is subordinate to its exempt parent:
    • Manager (i.e., Parent) exercises control of all business aspects of the PSC’s operations.
    • PSC obtains manager’s approval of its compensation agreements with physicians.
    • Manager approves the expenditures of the PSC.
    • Shareholder becomes a party to MSA.
    • PSC and Shareholder abide by terms and conditions of an SCA acceptable to Manager.
    • PSC ensures that all outstanding shares are at all times owned by a licensed physician employed by Manager or its affiliate.
    • PSC irrevocably appoints Manager as its agent and attorney in fact with full power to enforce the terms of the SCA.
    • Manager serves as PSC’s sole manager.
    • MSA renews automatically unless terminated.
    • MSA provides that Manager may terminate at any time without cause with 30 days’ notice, or immediately upon the occurrence of certain specified contingencies.
    • MSA allows PSC to terminate only by mutual written agreement, bankruptcy, or breach of MSA.
  • The Parent can control the shareholder through an Employment Agreement, by making his ownership of the stock depend upon his employment by the Parent, and his employment upon the PSC’s compliance with the Parent’s recommendations concerning all important aspects of the PSC’s operations, including employee compensation.

Other issues

  • If state licensing laws do not permit the Parent to appoint the PSC’s board, the PSC may nevertheless qualify for exemption if, by some combination of mechanisms, the Parent indirectly controls the PSC’s board. For example, the SCA or employment agreement can be used to control the shareholder’s choice of board members, by providing that the shareholder can vote only as approved in advance by the Parent.
  • The PSC and the Parent should have safeguards in place to ensure that compensation of physician employees is reasonable. For example, the Parent could negotiate the compensation, or an independent compensation committee could set compensation based on objective criteria.
  • If state law requires the stockholder to have beneficial as well as legal title to the stock, the PSC will probably not qualify for exemption. Seek assurance that there is no such requirement. Such assurance could come, for example, in the form of an opinion from the state attorney general.
  • The PSC should maintain its own charity care policy for its activities to further the exempt purpose of the Parent. The Parent’s charity care policy is not sufficient.
  • Ask the Parent of the applicant to provide the following written representations:
    • The Parent's SCA with the physician shareholder is “enforceable at law and in equity.”
    • The Parent “will not suffer or permit the physician shareholder (together with all successors, heirs and assigns of the physician shareholder and all subsequent designees holding the corporation's stock) to financially benefit in any manner, directly or indirectly, from the physician shareholder's legal ownership of the stock of the corporation as the designee and fiduciary of” the Parent.”
    • The Parent “will expeditiously and vigorously enforce all its rights in the shareholder control agreement and will pursue all legal and equitable remedies to protect its interest in the assets and stock of the corporation.”

Issue Indicators

  • Carefully review all organizational documents. The presence or absence of the appropriate agreements (shareholder control agreement, management service agreement, or employment agreement) can help determine what development is necessary for further consideration
  • Consider whether the applicant described, in detail, the methods and procedures through which the exempt parent controls the shareholder; If there are indicators of a lack of control by the exempt parent you should consider further development or consultation with counsel, if appropriate.

Audit Tips

  • Review the organization’s application for recognition as an organization exempt under IRC Section 501(c)(3). These documents should have established adequate control by the exempt parent.
  • Carefully review the state law when performing a field examination of an entity that is engaged in CPOM.

1 This analysis assumes the organization is formed as a corporation, however the organization may be formed as some other type of legal entity allowable under the laws of the state, such as an LLC. Note, however, that this Issue Snapshot will focus on the Corporate Practice of Medicine by organizations formed as corporations.

2 Note, ‘lay controlled corporations’ as used in this document refers to organizations controlled by laypersons, as distinguished from corporations run by physicians.

3 State law may provide for specific exceptions; for hospitals, for example.

4 Although meeting the integral part test suffices for the operating test, traditionally applicants have also provided or been asked to provide information to establish that they also meet the “flexible community benefit standard" derived from Rev. Rul. 69–545. However, if the applicant does not meet the flexible community benefit standard, denial is not necessarily indicated.