Tax treatment of the physician group practice

MGMA Connexion, Aug 2004 by Saner, Robert II, Miller, Jennifer Searfoss

Implications of the Pediatric Surgical Associates decision

Physician-owned medical group practices operate under a variety of corporate and partnership structures depending on liability considerations, state laws applicable to professionals and tax considerations. A 2001 decision of the U.S. Tax Court has put a cloud over groups structured as professional corporations that are taxed as traditional C-corporations under Subchapter C of the Internal Revenue Code and that are legal entities separate and distinct from the stockholders.

Pediatric surgical practice paid physicians without declaring dividends

The tax case, Pediatric Surgical Associates PC vs. Commissioner of Internal Revenue involved a group practice with four physician owners and two physician employees.1 The owners were paid a monthly draw with periodic bonuses; employees received flat salaries. The employed physicians were on a twoyear partnership track and did not perform significant administrative duties.

Pediatric Surgical Associates Inc., Fort Worth, Texas, was organized as a personal services corporation under state law and taxed as a C-corporation. The group used the cash method of income tax accounting, "bonused out" to owners in equal shares and as W-2 compensation for substantially all of the practice's net profit each year, and declared no dividends.

Audited by the Internal Revenue Service (IRS) for two years, the group paid owner compensation of $1.3 million and $1.5 million. The practice characterized these sums as payment for personally performed medical services and deducted the full amounts for tax purposes. The IRS disallowed a portion of the deductions, and the tax court agreed.

Salaries paid by a C-corporation, if "reasonable," are deductible as business expenses, but dividends are not. Practices taxed as C-corporations have historically characterized payments to physician owners as salaries in an effort to reduce - if not eliminate - taxes at the corporate level. The payment of dividends, resulting in taxation at both the group and individual shareholder levels, is relatively rare in group practices. Whether payments to owners are reasonable compensation for services rendered to the corporation, and not disguised dividends, is fair game in an IRS audit.

Tax court finds compensation arrangement illegal

C-corporations are permitted under Internal Revenue Code (IRC) � 162(a)(1) to deduct expenses incurred by the business, including "salaries or other compensation for personal services actually rendered" by the physician owners.2 This law establishes a two-pronged standard for evaluating shareholder compensation. Payments must be "reasonable" and compensate the owner for personally performed services. Compensation exceeding the reasonable value of a physician's personally performed services falls outside this provision and thus is nondeductible.

In Pediatric Surgical Associates, the court held that bonus payments made to the physician owners over a two-year period included profits derived from the services of the physician employees. The court characterized these payments as disguised dividends and ruled that the group violated IRC � 162(a)(1), as the bonuses included revenue from nonpersonally performed services. Instead, the court reasoned that these funds should have been distributed to the physician owners separately as dividends.

Ultimately, the court disallowed a portion of the group's tax filings and assessed a 20 percent penalty for negligence and intentional disregard of tax rules and regulations.

Previous decision muddies the issue

A tax court decision issued 10 years ago also muddies the deductibility of shareholder compensation derived exclusively from ancillary revenue streams. In Richlands Med. Association vs. Commissioner, the 1RS allowed the medical practice to classify shareholder compensation amounts up to the full amount of their professional collections as personally performed services.3 Because virtually no group can afford to pay many of its physicians at a level exceeding gross collections, the case had little impact.

The Pediatrics court commented on Richlands, noting that it does not establish a rule of law that compensation is always deductible up to gross collections. Instead, the court suggested that it might have held differently in Richlands had the IRS not conceded the point.

Pairing the Richlands principle on ancillary profits and the reinterpretation of gross collections with the Pediatrics holding on employee-derived profits, the IRS has a powerful combination of theories to challenge shareholder compensation as being in part a distribution of nondeductible dividends.

Impact on group practices

Whether the IRS will pursue these issues aggressively in future audits remains to be seen. If it does, practices have at least two options.

First, groups can change their profitsharing arrangements. The Pediatrics group used an equal-shares method for dividing bonuses among physician owners. Instituting a productivity-based profit-sharing formula might lessen IRS scrutiny by attributing funds to personally performed services, although it would not eliminate the aspect of the Pediatrics decision that relates to employee-derived profits.