Investment funds pursue opportunities to invest in operating companies across many industries. Healthcare investments, however, are more complicated since most state regulations restrict ownership of medical practices to licensed professionals. These rules are commonly referred to as the corporate practice of medicine (CPOM) and apply to medical, dental, veterinary, and other regulated industries. To address these restrictions, investment funds have adopted structures that separate medical practices owned by licensed physicians from unregulated management companies that provide services to such medical practices. These structures allow for investment into the healthcare industry but bring tax complexity with them, specifically during periods of operation and transactions — both acquisitions and an ultimate sale of the platform. We examine these structures and their tax attributes in depth.
- The evolution of investment structures
- General tax characteristics of MSO structures
- Tax consolidation of the MSO and medical practice
- Planning for a sale transaction
- Managing the present and future
The evolution of investment structures
As investment funds sought to enter the healthcare sector, they were faced with the challenge of navigating the CPOM rules while establishing structures that would facilitate their investment. Direct investment into practices is widely prohibited by states under CPOM rules. Moreover, lending transactions don’t provide the same investment return opportunities as equity and are limited based on the balance sheets of medical practices. The solution to this problem came in the form of a management company that would provide services to practice entities, and which would not be subject to the same rigorous limitations on outside investment.
MSO structures
A management service organization (MSO) provides a variety of services to licensed medical practices pursuant to a management services agreement (MSA). Such services are broadly defined to include administrative functions (scheduling, billing, and collections), human resources, technology support, internal accounting and bookkeeping, and strategic consulting, among others. Importantly, such services are nonregulated and are distinct from the provision of medical services, which is completed by the licensed practice. By separating medical services from other business operations, this structure is intended to allow each business — the medical practice and the MSO — to operate more efficiently and effectively.
The legal and economic relationships among the MSO, the medical practice, and the licensed physicians often extend beyond the provision of services. For example, a physician that owns the medical practice subject to the MSA may agree to a stock transfer restriction, limiting the ability to sell stock in the medical practice without the consent of the MSO. Physicians operating within the medical practice are also subject to employment agreements and noncompete agreements. Such physicians may also obtain equity interests within the MSO itself. The MSO may obtain the ability to select board members for the medical practice or exercise similar forms of control. However, the specific parameters of these MSO arrangements vary depending on the state in which the medical practice operates. State legislatures periodically revisit the CPOM rules, so the landscape continues to evolve.
Growth through acquisitions
The expansion of an MSO structure, including its affiliated practice entities, is fueled through a combination of organic growth (e.g., advertising-driven patient recruitment) and acquisitions of new practices. The CPOM rules also require a bifurcated approach to acquisitive transactions, which are typically separated into two distinct aspects:
- Nonmedical acquisition. The MSO will generally acquire nonmedical assets in a taxable purchase from the medical practice, an affiliate of such practice, or licensed physicians themselves. This portion of the transaction may involve cash consideration, deferred or contingent proceeds, or rollover equity in the MSO. Funding for such acquisition is generally raised through a combination of debt of the MSO and equity contributions to the MSO, including rollover contributions.
- Medical tie-up. Unless the target medical practice operates within a state that doesn’t apply CPOM rules, then any medical-related assets can only be directly acquired by a licensed entity. Typically, this results in the target practice retaining all its medical assets and entering into a new MSA with the acquiring MSO. Alternatively, if the MSO already has an affiliated medical practice in the relevant state, then such entity may be able to acquire the medical assets of the target practice in a taxable transaction.
Following the closing of an acquisition, the MSO takes over the administrative and other services, and the medical practice begins to operate within the overall structure.
General tax characteristics of MSO structures
The tax attributes of an MSO and its affiliated medical practice are intertwined in various respects. Here are the most common tax structures:
- The MSO. The MSO is typically treated as a partnership or C corporation for tax purposes and recognizes the majority of its income in exchange for the performance of services pursuant to the MSA. Operating expenses will also be incurred by the MSO in performance of its services.
- Medical practice. Practice entities are often structured as professional corporations or professional limited liability companies. From a tax viewpoint, the practice entities affiliated with an MSO generally elect to be treated as C corporations either by default classification or through a check-the-box election. Medical practices generate revenue based on their billings to patients and insurance companies. Expenses at the practice entity include wages, operating costs, as well as payments under the MSA. Given the terms of such arrangements, the net taxable income recognized by the practice entity is often modest.
While the medical practice and MSO must be legally structured as separate entities with different ownership structures, a threshold question is whether such structure will be respected for tax purposes. An alternative view would be that the substance of the agreements among the parties may instead confer tax ownership of the medical practice to the MSO despite a formal legal title being held by a licensed doctor.
Tax consolidation of the MSO and medical practice
The starting point for the tax consolidation view is case law on beneficial ownership. Relevant authorities examine the rights associated with ownership and consider the substance of the overall arrangement among the parties. Going further, the IRS has applied the beneficial ownership concept in private letter rulings (PLRs), allowing corporate medical practices to join the consolidated group of corporations operated by the MSO. In such cases, the legal ownership of the medical practices by doctors was outweighed by the substantive control and economic rights of the MSO. The IRS hasn’t directly offered statements on consolidation of tax filings outside of affiliated groups of corporations, but the case law related to beneficial ownership would apply equally in such situations.
Examining beneficial ownership
In determining tax ownership for federal income tax purposes, courts and the IRS have consistently emphasized the importance of the benefits and burdens of ownership over mere legal title. While legal title may indicate nominal ownership, it’s not dispositive. Instead, tax ownership is often attributed to the party who bears the economic benefits and risks associated with the property. Relevant authorities include Revenue Rulings 70-469 and 84-79, Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981), and Anschutz Co. v. Commissioner, 664 F.3d 313, 315 (10th Cir. 2011). The principle of beneficial ownership has been applied across various contexts, including real estate, investment assets, and increasingly, business entities. In the case of business ownership, courts have looked beyond formal documentation to assess who truly controls the entity, receives its profits, and bears its losses.
Courts have used many criteria to determine which party is the beneficial owner of property. No matter the criteria that a court uses, it’s ultimately attempting to determine which party actually enjoys ownership of the property, even when the legal title might not be consistent with that enjoyment. The following test, primarily drawn from Anschutz, describes the key factors for evaluating whether the licensed physician or the MSO may be considered the tax owner of a medical practice subject to the MSA:
- Which party has the opportunity for gain?
- Which party bears the risk of loss?
- Which party has dividend rights?
- Which party has voting rights?
- Which party has the right to sell the property?
- Which party has an equity in the property?
- How do the parties treat their ownership of the property?
- Which party has legal title?
- Which party has the right of possession?
- Does a contract create obligations for each of the parties?
When reviewing existing or planned structures, the totality of agreements should be reviewed to better understand the applicable rights and responsibilities.
Consolidation in corporate and noncorporate structures
The clearest examples of consolidation are found in the context of MSOs and medical practices that are both treated as C corporations for tax purposes. There, the IRS has ruled that medical practices could join the consolidated federal income tax return of the MSO group. Representative examples of such guidance include: PLR 201451009, PLR 202049002, PLR 202417008, and PLR 202607011. The facts represented by the taxpayers in those PLRs are unremarkable and generally follow the MSO arrangement described above. In a corporate context, it’s possible to request a PLR to overtly obtain IRS consent to consolidate the medical practice(s) with the MSO.
The above-mentioned PLRs considered corporate structures and provided relief for corporate practices to join a consolidated group of corporations. However, the same rationale, based on a beneficial ownership analysis, would also apply in structures where the MSO isn’t a corporation. Corporate medical practices that are subject to MSAs generally report as C corporations rather than S corporations for this exact reason. The C corporation medical practice can’t be consolidated from a tax return perspective with an MSO partnership, so separate tax filings are required. Alternatively, a medical practice that’s wholly owned by the physician and is treated as a disregarded entity might be consolidated with an MSO partnership (e.g., included as a disregarded subsidiary of the MSO partnership).
One final item to consider is whether the arrangement among the parties could be considered to establish a joint venture partnership for tax purposes. The relevant case for this purpose is Luna v. Commissioner, 42 T.C. 1067 (1964), which detailed eight factors for this analysis. Although an illustrative example of the analysis is found in Technical Advice Memorandum 199922014, it concluded that there was no partnership when an MSO and a service company entered into an MSA. However, a tax partnership is generally not expected to result from an MSO structure.
Planning for a sale transaction
An investment fund seeking an exit from its MSO business is confronted with a variety of tax structuring considerations. Ideally, exit planning would happen long before negotiations with a buyer begin in earnest. Advanced lead time creates an opportunity to evaluate the existing structure, consider any restructuring options, and examine exit transaction models to understand the tax character of gains and deductions.
Structuring corporate MSO exits
Shareholders in a corporate MSO structure have an interest in selling their corporate stock rather than having the MSO sell its operating assets in a taxable event. There’s nothing special about medical structures in this respect. Specifically, selling corporate stock would result in a single level of capital gains tax at the shareholder level (maximum 20% rate for federal long-term capital gains, plus the 3.8% net investment income tax). Alternatively, double taxation would result if assets were sold, triggering a 21% federal corporate level tax with the resulting net cash being distributed in a taxable dividend or redemption (again, subject to a maximum 20% rate, plus the 3.8% net investment income tax for federal purposes).
The nature of the assets sold by the MSO corporation wouldn’t matter for federal income tax purposes given the single 21% federal tax rate applicable to income recognized by a C corporation. However, the asset transaction would result in a tax basis step-up to the buyer in the acquired assets, which would generate meaningful tax deductions over time. An asset type of transaction is often structured as a sale of membership units in one or more single-member LLCs that are disregarded for federal income tax purposes. That type of structure allows the existing MSAs or amended MSAs to be kept in place. If the stock of the MSO itself were to be sold, then a similar dynamic would be present.
Structuring partnership MSO exits
The situation becomes more complex if the MSO is structured as a partnership for tax purposes. More specifically, the character of gain to be recognized by the partners in the partnership is tied to the underlying assets of the business. Some assets will generate ordinary income and may be subject to tax at the highest ordinary income tax rates. The sale of other assets will trigger gains that are capital in nature and will be subject to favorable tax rates (maximum 20% rate for federal long-term capital gains, plus the 3.8% net investment income tax depending on the tax status of the partner). This dynamic is present irrespective of whether the MSO partnership sells its assets, the partners sell their interests in the MSO partnership, or the sale occurs at an upper-tier partnership (itself a partner in the MSO). In the partnership interest sale, Section 751 provides the operative rules requiring ordinary income recognition when unrealized receivables or inventory items (collectively commonly known as “hot assets” or “Section 751 property”) exist within the partnership.
Several categories of MSO assets require evaluation for the potential recognition of ordinary income in a sale transaction. MSOs are service companies that generally follow the accrual method of accounting and hold modest amounts of fixed assets. This means that the potential depreciation recapture in a sale transaction is generally a small portion of the total gain to be recognized. Amortization recapture from the sale of previously purchased intangible assets could generate a larger amount of ordinary income. Additionally, inventory is usually limited, and the accrual method reduces the potential for taxable gain on the sale or deemed sale of accounts payable and other working capital assets. Thus, the topic that may complicate the tax character of gains in the sale of an MSO partnership is the potential allocation of purchase price to the MSA.
When considering the potential purchase price allocation to an MSA, there are three questions to be addressed:
- Will the MSA be regarded for tax purposes? For example, a contract between an MSO and a disregarded subsidiary would generally not be an asset for tax purposes. However, a contract between legal entities that are respected for tax purposes would be considered an asset.
- Does the substance of the MSA require it to be considered an asset to which value could be allocated? The rights of the parties to cancel the contract, the structure of services to be performed and payments to be received, and the overall economic arrangement are relevant facts for this purpose.
- What is the fair market value of the MSA? Even if purchase price might be assigned to the MSA, then a valuation question follows.
This is an evolving area of tax law. Courts have liberally interpreted what constitutes a contract or agreement for purposes of Section 751, focusing on the substance of the partnership’s legal right to payment as opposed to contract formalities. Where there’s a contract requiring an allocation of purchase price, then the parties must negotiate such amount. Still, it’s notable that the IRS isn’t bound by any agreement among the parties to a transaction for purchase price allocation. For example, in Ledoux v. Commissioner, 77 T.C. 293 (1981), the taxpayer was a partner in a partnership that managed a dog track under a long-term management contract (twice extended). Although the partnership held certain other assets, the parties agreed that the value of the partnership was largely attributable to the management contract. Ultimately, the court held that the partner’s gain on the sale of his interest, which was attributable to the income to be earned by the partnership during the remainder of the contract, constituted ordinary income.
When planning for a sale transaction, the investment fund and management of the MSO should take steps well in advance to better understand and model the potential tax ramifications. With proper lead time, the business entities might be restructured, tax positions related to beneficial ownership might be built, existing agreements could be amended, and valuation work might be undertaken.
Managing the present and future
The CPOM rules are a critical factor and require careful consideration in any healthcare-related investment structure. As the market has evolved, the MSO structure has become a widely adopted vehicle to balance the many interests of the parties. Though it brings certain tax complexities, those are generally viewed as manageable.
Investment funds with existing healthcare structures or those pursuing next structures should be vigilant about changes under state law. Any legislative changes may impact the contractual relationships among the parties and require amendments. Moreover, current structures should be revisited as part of future exit planning to better understand the amount and character of gain that might be recognized.
