Doctor's Surgery Activities Can't be Grouped with Surgical Rental Business

(Parker Tax Publishing February 2017)

The Tax Court held that a doctor was correct in recategorizing income from nonpassive to passive and the IRS could not regroup the doctor's plastic surgery activity with his investment in a business entity that rents out surgical space. However, because the issue was not previously raised, the doctor was not entitled to use that recharacterized passive income to offset prior year passive losses. Finally, because the doctor was an investor in the surgical space rental activity and was not involved in the operations of the business, his distributive share of income from that business was not subject to self-employment tax. Hardy v. Comm'r, T.C. Memo. 2017-16.

Facts

Dr. Stephen Hardy is a plastic surgeon who conducts his medical practice through Northwest Plastic Surgery Associates, a single-member professional LLC treated as a partnership. His wife is the chief operating officer. Dr. Hardy performs surgeries in various facilities, one of them being the Missoula Bone & Joint Surgery Center, LLC (MBJ), an LLC formed by a group of practicing physicians for the purpose of operating a surgery center. In 2006, Dr. Hardy purchased a 12.5 percent interest in MBJ for $164,000. MBJ is treated as a partnership for tax purposes and is professionally managed. It hires its own employees and does not share any employees with Northwest Plastic Surgery. MBJ directly bills patients for facility fees and then distributes to each of its members his or her share of the earnings based on the facility fees less expenses. MBJ uses an accounting firm to prepare its taxes and K-1s and does not pay physicians for their medical procedures.

During 2008 through 2010, Dr. Hardy performed approximately 50 percent of his surgeries at his office at Northwest Plastic Surgery Associates, 20 percent at MBJ, and the remainder at other facilities. Dr. Hardy received a distribution from MBJ regardless of whether he performed any surgeries at the surgery center.

For 2006 and 2007, Dr. Hardy and his wife, reported the income from MBJ as nonpassive. Their CPA had determined that such classification was appropriate because the K-1s the Hardys received stated that the income was from a trade or business and the K-1s included self-employment tax. The CPA did not group Dr. Hardy's medical practice activity with his ownership interest in MBJ. For both 2006 and 2007, the Hardys also reported unallowed passive activity losses.

In 2008, after learning that Dr. Hardy was not involved in the management of MBJ and was not liable for the debts of MBJ, the Hardy's CPA determined that the income from MBJ was passive and began reporting it as such. The passive income allowed the Hardys to absorb unrelated passive activity losses. The CPA did not amend the Hardys' returns for 2006 or 2007 because he believed the change would be immaterial. For 2008 and 2009, the Hardys calculated and reported self-employment tax on the income Hardy received from Northwest Plastic Surgery and MBJ. They did not do so for 2010.

The IRS issued a notice of deficiency for 2008 through 2010 recharacterizing the MBJ income as nonpassive and determining deficiencies. The Hardys took their case to the Tax Court.

IRS and Taxpayer Arguments

The IRS argued that the income from Dr. Hardy's medical practice and MBJ should be grouped together as nonpassive income. Before the Tax Court, the IRS inferred that the Hardys had already grouped the ownership interest in MBJ with the medical practice because they had previously reported the income from both activities as nonpassive, thus they were bound to continue reporting the income that way. Alternatively, citing Reg. Sec. 1.469-4(f) and an example contained in that regulation, the IRS argued that it had the authority to regroup Dr. Hardy's activities.

The Hardys argued that Dr. Hardy's ownership interest in MBJ and his medical practice should not be grouped together because they did not constitute an appropriate economic unit as a single activity. Also, they noted, they had not previously grouped the activities together. The Hardys pointed out that the activities are different types of businesses: MBJ is a rental surgical facility and Dr. Hardy's practice is an active medical practice. Additionally, they argued, they did not have a principal purpose of circumventing Code Sec. 469 when they treated the activities as separate because Dr. Hardy did not join MBJ to artificially create a passive activity loss. Rather he had a business purpose for joining MBJ.

Also, at trial, the Hardys argued that they overpaid self-employment tax for 2008 and 2009 because they should not have paid self-employment tax on the MBJ income.

Tax Court's Decision

The Tax Court held that the Hardys' income from MBJ was passive income and that Dr. Hardy's ownership interest in MBJ should not be grouped with his medical practice. The court refused to infer that the Hardys grouped Dr. Hardy's ownership interest in MBJ with his medical practice because, it said, such a grouping was not supported by the evidence. The mere fact that the Hardys reported Dr. Hardy's activities as nonpassive was not enough for the court to conclude that the Hardy's had grouped Dr. Hardy's ownership interest in MBJ with his medical practice.

The court also refused to allow the IRS to regroup Dr. Hardy's activities. The court noted that the IRS can only regroup a taxpayer's activities where -

(1) any of the activities resulting from the taxpayer's grouping are not an appropriate economic unit; and

(2) a principal purpose of the taxpayer's grouping is to circumvent the underlying purposes of Code Sec. 469.

Each requirement must be met, the court observed, in order for the IRS to be able to regroup a taxpayer's activities. In concluding that the IRS did not have a reason to regroup, the court cited TAM 201634022 which had facts similar to the Hardys' situation and which was distinguishable from the example in the regulations that had been cited by the IRS. The court noted that there was more than one reasonable method of grouping Dr. Hardy's activities. While the court found that some facts supported treating Dr. Hardy's ownership interest in MBJ and his medical practice as a single economic unit, the weight of the evidence supported treating them as separate economic units. The court cited the fact that (1) Dr. Hardy was the sole owner of his medical practice and only a minority owner of MBJ; (2) Dr. Hardy actively managed his medical practice but did not have any management responsibilities in MBJ; (3) Dr. Hardy's medical practice and MBJ did not share any building space, employees, billing functions, or accounting services; and (4) Dr. Hardy performed services different from MBJ's services.

The court then addressed the proper amount of the passive activity loss carried over to 2008 from prior years. The court noted that, had the Hardys properly reported the MBJ income as passive for 2006 and 2007 rather than erroneously reporting it as nonpassive, it would have fully absorbed their passive losses and there would have been no passive loss to carryforward to 2008. The court thus held that the Hardys were not entitled to the full passive activity loss deduction carried forward into 2008. The court rejected their argument that, under the doctrine of equitable recoupment, they were entitled to the deduction on the basis that they had not previously argued this defense.

Finally, the Tax Court held that, because Dr. Hardy received his distributions from MBJ as a limited partner acting in his capacity as an investor, he was not liable for self-employment tax on his income from MBJ. In reaching this conclusion, the court cited Renkemeyer, Campbell & Weaver, LLP v. Comm'r, 136 T.C. 137 (2011). The court contrasted Dr. Hardy's limited partnership interest in a surgical facility with a limited partnership interest in a law firm in which the partner was an active participant in the practice.

For a discussion of the grouping rules for purposes of determining passive and nonpassive income, see Parker Tax ¶247,110.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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