IRS cannot force regrouping of separate medical activities

Plain-English summary

A physician treated interests in two medical practices and a partnership that indirectly owned part of an outpatient surgery center as separate activities for passive-loss purposes. The separate treatment allowed passive income from the partnership to offset losses from a rental property. The IRS concluded that more than one reasonable grouping method could apply under the five-factor test in Treas. Reg. § 1.469-4(c). Because the chosen grouping was not clearly inappropriate and the facts did not show a principal purpose of avoiding IRC § 469, the Commissioner lacked authority to regroup the three interests as one activity.

Ruling snapshot

• Question: May the Commissioner regroup the physician's medical-practice and surgery-center interests as one activity under the passive-activity rules?
• Outcome: Advice given, forced regrouping was not authorized on the presented facts
• Key authorities: IRC § 469; Treas. Reg. § 1.469-4(c), (e), and (f)

Full text (IRS public release)

INTERNAL REVENUE SERVICE
NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

April 05, 2016
Number: 201634022
Release Date: 8/19/2016
Third Party Communication: None
Date of Communication: Not Applicable

Index (UIL) No.: 469.03-03
CASE-MIS No.: TAM-100660-16

Chief, Appeals Office
Denver, CO

Taxpayer's Name: --------------------------------
Taxpayer's Address: --------------------

Taxpayer's Identification No: ------------------
Year(s) Involved: ----------------
Date of Conference: No Conference Held

LEGEND:

H = ---------------------
P = -------------------------------------------------
Q = -------------------------------
R = -------------------------------
W = ------------------------
X = ------------------------------------------------------------------------------------------

Y = -----------------------------------------------------------------------
Z = ----------------------
Center = ---------------------------------
City = ----------------------------
Hospital = ------------------------
Date1 = ------------------------
Date2 = ---------------------------
State1 = -----------------
State2 = -----------------
Year1 = -------
Year2 = -------

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Year3 = -------
N1 = ----
N2 = -----
N3 = --------
N4 = --------
N5 = ----
N6 = ----
N7 = ----
N8 = --
N9 = ------
N10 = -----
N11 = -----
N12 = -----
N13 = ------
N14 = -----
N15 = ----
N16 = -----
N17 = -----
N18 = ----------
N19 = ----------
N20 = ----
N21 = ----------
N22 = ----------
N23 = ----------
N24 = ----------

ISSUE(S):

Whether the facts and circumstances of this case as described below support or
require a determination that one or more of the taxpayers’ groupings of activities do not
constitute an appropriate economic unit within the meaning of § 1.469-4(c) of the
Income Tax Regulations (“regulations”), for purposes of § 469 of the Internal Revenue
Code (“Code”), such that the taxpayers’ activities must be regrouped under either the
general regrouping rule of § 1.469-4(e)(2) or the Commissioner’s regrouping authority of
§1.469-4(f) to prevent tax avoidance.

CONCLUSION(S):

We conclude that the facts and circumstances of this case, as presented and
analyzed under the five-factor test of § 1.469-4(c), suggest that there may be more than
one reasonable method for grouping the taxpayers’ activities into appropriate economic
units. We also conclude that the facts and circumstances, as presented, do not support
a determination that the taxpayers’ grouping of the interests in X, Y, and P as separate

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activities is clearly inappropriate for purposes of either § 1.469-4(e)(2) or § 1.469-4(f).
We further conclude that the facts as presented do not support a determination that H
acquired his interest in P and treated it as a separate activity apart from X and Y with a
principal purpose of circumventing the underlying purpose of § 469, for purposes of
§ 1.469-4(f). Therefore, we conclude that the Commissioner does not have authority to
regroup the taxpayers’ interests in X, Y, and P as a single activity under § 1.469-4(f) to
prevent tax avoidance.

FACTS:

The taxpayer husband, H, is an otolaryngologist (an ear nose & throat doctor). H
was an employee of X through Date1. X was an S corporation, and H owned N1% of
the stock of X in Year1. H left the employment of X on Date1 and became an employee
of Y beginning Date1 through Date2. Y was an S corporation, and H owned N2% of Y
during this period of employment.

H also held a small ownership interest in Year1 and Year2 in P, which is
classified as a partnership for federal tax purposes. H owned an average of N3% of P
in Year1 and N4% in Year2. P, in turn, owns N5% of R which is classified as a
partnership for federal tax purposes. The other N6% of R is owned by Q, which is
classified as a partnership for federal tax purposes and which has ownership interests in
similar facilities throughout the country. A total of N7 physicians from N8 different
medical practices in the City area held ownership interests in P in Year1, including H.

R provides outpatient surgery facilities for qualified licensed physicians. While
physicians were required to meet certain certification standards in order to use R’s
facilities, the physicians were not required to be owners of R or be in practice with an
owner of R in order to use its facilities. R is used extensively by non-owner physicians
or surgeons in the City area.

H has represented that, under applicable local law, physicians are not permitted
to refer patients to an entity in which they have a financial interest. Instead, patients
must be given a choice in surgery location. However, patients will often choose R over
a hospital due to its lower cost. The charge for surgery at a hospital is generally much
higher than at an independent outpatient surgery center such as R.

According to the taxpayers’ submission, the income generated from H’s indirect
ownership in R (through P) is not tied to the number of surgeries he performs at R’s
facility or to the revenue generated by those surgeries. Moreover, even if H did not
perform any surgeries at R, he would still receive the same proportionate share of R’s
profits allocable to his ownership interest in P. Prior to the opening of R in Year3, the
surgeries that could not be performed in H’s practice office were performed at the local
Hospital. The opening of R did not affect H’s income from his medical practice, but his
patients were given a choice as to where to have the surgery performed. Moreover, the

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taxpayers argue that there are no interdependencies between X, Y, and R. H was
compensated for his surgical services to patients through medical charges made by X
or Y. The revenue generated by R through facility charges are separate from the
charges for medical services rendered by H to his patients.

The number and locations of surgeries performed by H in Year1 are as follows:
N9 surgeries performed at R; N10 surgeries performed at Hospital; N11 surgeries
performed at X offices; N12 surgeries performed at Y offices; and N13 surgeries
performed at Center. The number and locations of surgeries performed by H in Year2
are as follows: N14 surgeries performed at R; N15 surgeries performed at Hospital;
N16 surgeries performed at Y offices; and N17 surgeries performed at Center.

The taxpayers’ submission further states that P is a limited liability company that
was established by a group of physicians to acquire an interest in R. The owners of P
tend to be local City area physicians because they saw a benefit to having a surgical
facility in the City area which would give City area patients a lower-cost choice for their
surgical needs as opposed to Hospital being the only available surgical facility. The
taxpayers represent that H’s investment in P was not made to improve, increase, or
change H’s medical practice.

The taxpayers, H and W, filed joint returns for Year1 and Year2 and treated P as
a separate activity from X and Y. The taxpayers incurred a passive loss of $N18 on a
rental condo located in State2 in Year1, identified on their return as Z. The taxpayers
had $N19 in carryover suspended losses for prior years from the Z condo. The
taxpayers had $N20 of other passive income and $N21 of income from P that the
taxpayers treated as passive income in Year1. Accordingly, the entire $N22 loss from
the Z condo was deducted in Year1. In Year2, the taxpayers incurred a $N23 passive
loss on the Z condo. The taxpayers reported $N24 of passive income from P, allowing
the taxpayers to deduct the entire $N23 loss in Year2.

LAW AND ANALYSIS:

Section 469(a) of the Code disallows the passive activity loss or passive activity
credit for the taxable year of any taxpayer subject to § 469.

Section 469(c) provides that, for purposes of § 469, the term “passive activity”
means any activity (A) which involves the conduct of any trade or business, and (2) in
which the taxpayer does not materially participate.

Section 469(l)(1) provides that the Secretary shall provide such regulations as
may be necessary or appropriate to carry out provisions of § 469, including regulations
which specify what constitutes an activity, material participation, or active participation
for purposes of § 469.

TAM-100660-16 5

Section 1.469-4(b)(1) provides that trade or business activities are activities,
other than rental activities or activities that are treated under § 1.469-1T(e)(3)(vi)(B) as
incidental to an activity of holding property for investment, that (i) involve the conduct of
a trade or business (within the meaning of § 162); (ii) are conducted in anticipation of
the commencement of a trade or business; or (iii) involve research or experimental
expenditures that are deductible under § 174 (or would be deductible if the taxpayer
adopted the method described in § 174(a)).

Section 1.469-4(c)(1) provides, generally, that one or more trade or business
activities or rental activities may be treated as a single activity if the activities constitute
an appropriate economic unit for the measurement of gain or loss for purposes of § 469.

Section 1.469-4(c)(2) provides that, except as otherwise provided in § 1.469-4,
whether activities constitute an appropriate economic unit and, therefore, may be
treated as a single activity depends on all the relevant facts and circumstances. A
taxpayer may use any reasonable method of applying the relevant facts and
circumstances in grouping activities. The factors listed below, not all of which are
necessary for a taxpayer to treat more than one activity as a single activity, are given
the greatest weight in determining whether activities constitute an appropriate economic
unit for the measurement of gain or loss for purposes of § 469 –
(i) Similarities and differences in types of trades or businesses;
(ii) The extent of common control;
(iii) The extent of common ownership;
(iv) Geographical location;
(v) Interdependencies between or among the activities (for example, the
extent to which the activities purchase or sell goods between or among
themselves, involve products or services that are normally provided
together, have the same customers, have the same employees, or are
accounted for with a single set of books and records).

Section 1.469-4(c)(3) provides that the following examples illustrate the
application of § 1.469-4(c). Section 1.469-4(c)(3) Example 1 states that Taxpayer C
has a significant ownership interest in a bakery and a movie theater at a shopping mall
in Baltimore and in a bakery and a movie theater in Philadelphia. In this case, after
taking into account all the relevant facts and circumstances, there may be more than
one reasonable method for grouping C’s activities. For instance, depending on the
relevant facts and circumstances, the following groupings may or may not be
permissible: a single activity; a theater activity and a bakery activity; a Baltimore activity
and a Philadelphia activity; or four separate activities. Moreover, once C groups these
activities into appropriate economic units, § 1.469-4(e) requires C to continue using that
grouping in subsequent taxable years unless a material change in the facts and
circumstances make it clearly inappropriate.

TAM-100660-16 6

Section 1.469-4(c)(3) Example 2 states that Taxpayer B, an individual, is a
partner in a business that sells non-food items to grocery stores (partnership L). B also
is a partner in a partnership that owns and operates a trucking business (partnership Q).
The two partnerships are under common control. The predominant portion of Q’s
business is transporting goods for L, and Q is the only trucking business in which B is
involved. Under this section, B appropriately treats L’s wholesale activity and Q’s
trucking activity as a single activity.

Section 1.469-4(e)(1) provides that, except as provided in § 1.469-4(e)(2) and §
1.469-11, once a taxpayer has grouped activities under this section, the taxpayer may
not regroup those activities in subsequent taxable years. Taxpayers must comply with
disclosure requirements that the Commissioner may prescribe with respect to both their
original groupings and the addition and disposition of specific activities within those
chosen groupings in subsequent taxable years.

Section 1.469-4(e)(2) provides that if it is determined that a taxpayer’s original
grouping was clearly inappropriate or a material change in the facts and circumstances
has occurred that makes the original grouping clearly inappropriate, the taxpayer must
regroup the activities and must comply with disclosure requirements that the
Commissioner may prescribe.

Section 1.469-4(f)(1) provides that the Commissioner may regroup a taxpayer’s
activities if any of the activities resulting from the taxpayer’s grouping is not an
appropriate economic unit and a principal purpose of the taxpayer’s grouping (or failure
to regroup under § 1.469-4(e)) is to circumvent the underlying purpose of § 469.

Section 1.469-4(f)(2) provides that the following example illustrates the
application of § 1.469-4(f). Section 1.469-4(f)(2) Example states that Taxpayers D, E,
F, G, and H are doctors who operate separate medical practices. D invested in a tax
shelter several years ago that generates passive losses and the other doctors intend to
invest in real estate that will generate passive losses. The taxpayers form a partnership
to engage in the trade or business of acquiring and operating X-ray equipment. In
exchange for equipment contributed to the partnership, the taxpayers receive limited
partnership interests. The partnership is managed by a general partner selected by the
taxpayers; the taxpayers do not materially participate in its operations. Substantially all
of the partnership’s services are provided to the taxpayers or their patients, roughly in
proportion to the doctors’ interests in the partnership. Fees for the partnership services
are set at a level equal to the amounts that would be charged if the partnership were
dealing with the taxpayers at arm’s length and are expected to assure the partnership a
profit. The taxpayers treat the partnership’s services as a separate activity from their
medical practices and offset the income generated by the partnership against their
passive losses.

Section 1.469-4(f)(2) Example further states that, for each of the taxpayers, the
taxpayer’s own medical practice and the services provided by the partnership constitute

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an appropriate economic unit, but the services provided by the partnership do not
separately constitute an appropriate economic unit. Moreover, a principal purpose of
treating the medical practices and the partnership’s services as separate activities is to
circumvent the underlying purposes of § 469. Accordingly, the Commissioner may
require the taxpayers to treat their medical practices and their interests in the
partnership as a single activity, regardless of whether the separate medical practices
are conducted through C corporations subject to § 469, S corporations, partnerships, or
sole proprietorships. The Commissioner may assert penalties under § 6662 against the
taxpayers in appropriate circumstances.

The facts of this case are different from the example in § 1.469-4(f)(2). In the
example, in order to circumvent the underlying purposes of § 469, the doctors converted
a portion of their practices into a single passive income generator by contributing
equipment to a separate entity (which they controlled but in which they did not materially
participate) and leasing back the equipment at arms-length rates. Substantially all of
the partnership’s services were provided to the doctors or their patients, roughly in
proportion to the doctors’ interests in the partnership.

In this case, an unrelated entity, Q, is majority owner of R and controls the day-
to-day management of the surgical facility. H and the other partners of P do not have
any direct or indirect control over the day-to-day operations of R, unlike H’s clear control
over Y. In addition, the services provided by R to patients of P’s partners likely do not
comprise substantially all of R’s patient services, and it is even less clear that the
services provided by R to the patients of P’s partners will be roughly in proportion to the
partners’ interests in P (or their indirect interests in R).

Thus, while the example in § 1.469-4(f)(2) concludes that the partnership’s
activities do not separately constitute an appropriate economic unit, it is not necessarily
inappropriate to treat P’s activity as a separate economic unit in this case. Furthermore,
we do not believe that the facts clearly demonstrate that H acquired his interest in P
with a principal purpose of circumventing the underlying purpose of § 469. Accordingly,
we conclude that the Commissioner would not have the authority to regroup the
taxpayers’ interests in X, Y, and P as a single activity under §1.469-4(f) to prevent tax
avoidance, even if we were to otherwise conclude that taxpayers’ other groupings of
activities do not constitute appropriate economic units under § 1.469-4(c).

We further conclude that an analysis under the five-factor test of § 1.469-4(c)
demonstrates that there may be more than one reasonable method for grouping the
taxpayers’ activities into appropriate economic units in this case. While the trade or
business activities of X, Y, and R (held by H through P) are similar in that they are all in
the medical industry and involve the provision of medical services to patients, X, Y, and
R provide different types of medical services. Certain surgeries cannot be performed at
X’s or Y’s practice office, and diagnostic and post-operative care is not provided through
P or R. H does not have the same kind of management control over R that H exercises
over his own medical practice conducted through X or Y. H has different ownership

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interests among X, Y, and P. It also appears from the facts that X, Y, and R are in
different locations and do not share employees or recordkeeping. Accordingly, we
conclude that an analysis of the facts and circumstances of this case under § 1.469-4(c)
does not result in a determination that the taxpayers’ grouping of the interests in X, Y,
and P as separate activities is clearly inappropriate for purposes of either § 1.469-
4(e)(2) or § 1.469-4(f).

CAVEAT(S):

We express no opinion regarding whether H materially participated in P for any of the
years at issue, or whether H has appropriately accounted for the hours that he
performed surgeries at or with respect to R.

A copy of this technical advice memorandum is to be given to the taxpayer(s). Section
6110(k)(3) of the Code provides that it may not be used or cited as precedent.