Navigating the Tax Implications of the Friendly PC Model

For healthcare organizations in the U.S., securing funding can be crucial for continued growth. Yet, unlike for other businesses, structuring capital investment in healthcare organizations remains challenging due to corporate practice of medicine (CPOM) laws. These state-level regulations dictate the ownership structure of healthcare entities, often mandating that only licensed physicians can hold equity in a medical practice. The lack of uniformity in CPOM regulations across the U.S. further complicates the funding process, creating a difficult hurdle for healthcare organizations striving to expand and thrive.

In response to these challenges, the CPOM structure, or friendly professional corporation (PC) model, was created. This model is designed so that physician-owned healthcare organizations can secure venture capital (VC) and private equity (PE) funding without violating CPOM regulations. Further, depending on the structure, the friendly PC model can present potential tax opportunities, which potentially include the ability to file a consolidated federal income tax return.

What is the Friendly PC Model?

The typical friendly PC model involves two entities:

• The professional corporation (PC) — a separate legal entity that provides medical treatment and collects revenue from patients, insurance companies, Medicare, and Medicaid, and may be classified as either a professional corporation or a professional LLC depending on state law. The ownership of the PC is usually limited to licensed medical professionals. In the friendly PC model, the licensed physician shareholder is referred to as the “friendly physician” or the “friendly doctor.”
• The management services organization (MSO) — a separate legal entity, often owned by a PE firm, that provides back-office functions and other non-clinical services for the PC and charges a fee for these services.

The friendly PC model generally functions based on two legal agreements: a restricted stock agreement (RSA) and a management services agreement (MSA). The RSA legally assigns certain ownership rights of the friendly physician to the MSO. This agreement precludes the friendly physician’s right to vote and means they require permission from the MSO to take certain actions, such as declaring and issuing a cash dividend, liquidating the PC, merging the PC with another entity, or selling stock of the PC to anyone else.

Under the MSA, the MSO provides back-office and other services unrelated to the practice of medicine to the PC for a management services fee. The fee can be structured as a fixed amount or based on a formula, provided it meets arm’s length transfer pricing rules and does not violate CPOM laws (for example, the fee generally may not appear to be a profit-sharing arrangement according to most state CPOM regulations). 

The ultimate result of the RSA and the MSA in the friendly PC model is that the enterprise value of the aggregate business is transferred to the MSO, and the equity value of the PC is nominal. 

The Question of Beneficial Ownership

In the friendly PC model, the MSO typically receives effective control and economic ownership of the PC’s business, while the physicians who own the PC may make decisions only with regard to the practice of medicine and are restricted from exercising typical shareholder rights without permission from the MSO. This arrangement raises the question: Who is the beneficial owner of the PC for federal tax purposes — the friendly physician or the MSO? The answer to this question is important when determining how the PC will file its federal tax return — on a separate basis, or on a consolidated basis as part of the MSO’s affiliated group.

Courts and the IRS have issued various rulings and other guidance on what constitutes beneficial ownership. Himmel vs. C.I.R. identified the following as critical beneficial rights of ownership:

1. The right to vote to liquidate.
2. The right to receive continuing dividends.
3. The right to receive liquidation proceeds.

However, there is limited guidance from the Department of the Treasury and the IRS on the question of beneficial ownership as it relates to the friendly PC model. The American Bar Association Section of Taxation has submitted a request for guidance, but the response to that request is still pending at the time of writing this piece. Thus, whether an MSO beneficially owns a friendly PC remains a gray area and must be thoroughly analyzed on a case-by-case basis.

Consolidated vs. Separate Federal Income Tax Filings — Which is Better?

If the MSO is determined to beneficially own the friendly PC, a second question then arises: Should the PC join in the filing of a consolidated return as a member of the MSO’s affiliated group? 

To be a subsidiary member of an affiliated group, at least 80% of an includible corporation’s voting stock and at least 80% of the fair market value of all of its stock must be owned directly by one or more of the other corporations in the group. Courts and the IRS have ruled that for this purpose, beneficial ownership — not legal ownership — is considered. Therefore, the analysis of beneficial ownership in a friendly PC structure is important, as it determines whether the PC may file (or may be required to file) a consolidated federal income tax return with the MSO or whether the PC and the MSO must file separate returns. Each approach has its advantages and disadvantages, which are set out in the following chart:

In addition, states have their own rules regulating whether an organization must file a consolidated or separate return, with some states always requiring separate returns. 

Planning Ahead

While the friendly PC model may offer an avenue for healthcare organizations to secure much-needed funding, these models can pose tax opportunities as well as tax risk. Organizations contemplating the friendly PC model should consider working with a CPOM attorney and a third-party advisor to determine the most advantageous way to file their federal income tax returns based on their facts and circumstances. The omission of an includible corporation as well as the inclusion of a non-includible corporation when electing to file a consolidated federal return can result in a negative tax impact for other members of the affiliated group.

BDO professionals assist with beneficial ownership analyses and offer guidance to companies in determining whether to file consolidated or separate returns. We also can assist with preparing and submitting a private letter ruling request as well as help to set up a pre-submission conference with the IRS.

Regardless of how a company files, our team of tax professionals can provide guidance to help streamline the filing process on both the federal and state levels. We help companies develop robust documentation to support their filing methods and positions, helping them to understand and mitigate their tax risk in the process. 

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