Are independent contractor physicians really hospital employees?

Healthcare Financial Management, August, 1997 by Rebecca K. Lambeth

Before entering into a contractual relationship with a physician, a provider organization must understand whether, according to the IRS, the physician will be considered an employee or an independent contractor. Correct assessment of this relationship is important to avoid penalties for failure to withhold and pay taxes and possible disqualification of employee retirement plans.

The IRS's most recent rulings in this area, two technical advice memorandums issued in September 1995, appear to indicate a shift in the agency's approach when defining these relationships - it now seems more likely that contractual arrangements between hospitals and physicians that typically have been treated as independent contractor relationships will be considered employer-employee relationships.

The issuance of these memorandums may indicate the IRS's intention to crack down on what it perceives to be abuses of the independent contractor status in the healthcare industry.

In September 1995, the IRS surprised the healthcare industry when it issued two technical advice memorandums in which it found physicians in various contractual relationships with hospitals to be employees rather than independent contractors.(a) In reaching its conclusions, the IRS relied on guidelines it had previously used to determine whether a worker is an employee or independent contractor of a business entity.

In the 1995 rulings, however, the IRS appeared to shift from predicating its conclusions on the amount of control a hospital maintains over physicians' decision making and other activities to basing such conclusions on the degree to which physicians' activities are integrated into a hospital's operations. This change in focus should cause hospitals and other healthcare providers to reevaluate their contractual arrangements with physicians.

The IRS Rulings

The Internal Revenue Code adopts the "usual common law rules" in determining whether a worker should be classified as an employee or an independent contractor.(b) The right to control or direct the individual performing the services is the critical issue in this analysis. The IRS has identified 20 factors for determining whether sufficient control is present to establish an employer-employee relationship. These factors, set forth in Revenue Ruling 87-41, are shown in Exhibit 1.

When applying these factors in the 1995 memorandums, the IRS emphasized the extent to which the physician activities were integrated into the hospital operations as evidence of the extent of control maintained by the hospitals over the physicians. In the first memorandum, the IRS analyzed the contractual relationship between several physicians and a tax-exempt entity that operated an outpatient surgery center and a nursing home (the "Taxpayer").(c) The IRS determined that physicians who contracted to be members of the Taxpayers' EKG panel were employees of the Taxpayer, even though the physicians maintained separate private practices, provided their own professional liability insurance, interpreted EKGs for other parties with the Taxpayer's permission, and did not participate in any employee benefits offered by the Taxpayer to its employees.

In support of its conclusion, the IRS cited the following:

* The EKG panel members provided the Taxpayer with services that differed from the services offered by the physicians in their private practices;

* The physicians had been integrated into the Taxpayer's organization (ie, the EKG interpretation services were an essential means for the Taxpayer to ensure that its patients received appropriate levels of quality medical care and were a necessary and integral part of the Taxpayer's operation) the physicians were compensated on a fixed-fee basis and were not in a position to recognize a profit or loss from the services rendered; and the physicians were not responsible for hiring, supervising, or paying assistants);

* Each physician provided services on a regular, recurring basis, resulting in a continuing relationship between the two parties;

* The physicians did not advertise or hold themselves out to the general public to perform EKG interpretations; and

* Both parties maintained the right to terminate the relationship with 30 days written notice.

The IRS acknowledged the existence of factors that would support independent contractor status for the physicians. Nonetheless, the agency found that, on balance, the EKG panel members must be considered employees of the Taxpayer.

In the same memorandum, the IRS also found that a physician who had contracted to serve as the medical director for the Taxpayer's nursing home was an employee of the Taxpayer. This physician appeared to have entered into a fairly standard medical directorship agreement with the Taxpayer, whereby the physician maintained a separate private practice, provided administrative services to the nursing home, did not participate in the Taxpayer's employee benefits, and received a monthly stipend of $1,000 to $1,250. In support of its conclusion, the IRS cited the following factors: