In PLR 201904016, the IRS has ruled that a professional corporation (PC) formed by a Section 501(c)(3) public charity does not qualify for exemption under Section 501(c)(3) due to a failure to satisfy the organizational test, because the corporation's formation document does not include required language with respect to exempt purposes (despite such absence being due to state restrictions).

Facts

PC is a professional corporation formed and controlled by a Section 501(c)(3) public charity (Parent). PC's sole shareholder is an individual employed and selected by Parent. A Shareholder Control Agreement between PC, Parent and the sole shareholder specifies that the shareholder holds the shares solely for the benefit of Parent and exclusively in furtherance of charitable purposes. Parent retains ultimate control over PC's activities and finances.

PC's purpose, per its incorporation document, is to carry on the practice of medicine. The incorporation document does not include language regarding the disposition of PC's assets upon dissolution. PC represented — and supported with evidence — that the relevant licensing authority for the state in which PC was formed would not permit it to include in its incorporation document language regarding its Section 501(c)(3) purpose or dissolution. Accordingly, PC included such language in its by-laws.

Law

Under Reg. Section 1.501(c)(3)-1(a)(1), to qualify for exemption under Section 501(c)(3), an organization must be both organized and operated exclusively for purposes described in Section 501(c)(3).

Reg. Section 1.501(c)(3)-1(b)(1)(i) specifies that an organization is organized exclusively for one or more exempt purposes only if its articles of organization: (1) limit the purposes of such organization to one or more exempt purposes; and (2) do not expressly empower the organization to engage, otherwise than as an insubstantial part of its activities, in activities that in themselves are not in furtherance of one or more exempt purposes.

In addition, under Reg. Section 1.501(c)(3)-1(b)(4), an organization is not organized exclusively for one or more exempt purposes unless its assets are dedicated to an exempt purpose. In general, to be considered dedicated to an exempt purpose, such assets, upon dissolution, should, by reason of a provision in the organization's articles or operation of law, be distributed for one or more exempt purposes.

Ruling and analysis

Because PC's formation document does not limit its purposes to one or more exempt purposes (but rather simply to the practice of medicine), the IRS concluded that it fails the organizational test under Reg. Section 1.501(c)(3)-1(b)(1)(i). Furthermore, the IRS determined that PC fails the organizational test because its incorporation document does not have a dissolution provision as required by Treas. Reg. Section 1.501(c)(3)-a(b)(4). Although PC's by-laws may contain such language, the IRS explained that it does not consider PC's by-laws to be a formation document. Accordingly, the IRS ruled that PC failed to satisfy the organizational test and is not exempt under Section 501(c)(3).

Implications

Although not explicitly included in Section 501(c)(3) or in the accompanying regulations, the IRS has historically allowed physician professional corporations that have been formed in states that adhere to the corporate practice of medicine proscription to qualify as a tax-exempt organization under Section 501(c)(3). Generally, jurisdictions following the corporate practice of medicine proscription require a physician practice to organize as a professional services corporation rather than as a nonprofit corporation. Often, these laws mandate that all stock in the corporation providing the medical services be held by a physician duly licensed to practice medicine in the state and that all members of the board of directors be physicians duly licensed by the state to practice medicine, among other provisions.

The IRS has previously recognized the tax-exempt status of physician professional corporations that were formed in jurisdictions that follow the corporate practice of medicine proscription (see, e.g., University of Maryland Physicians v. Commissioner, T.C. Memo 1981-23 (1981)). The IRS has also released an Issue Snapshot regarding the tax-exempt status of physician professional corporations that exist in jurisdictions that follow the corporate practice of medicine proscription.

The IRS's determination in PLR 201904016 represents a departure from previous guidance that it has provided in the Issue Snapshot. Specifically, the Issue Snapshot highlights that the standard language required to meet the organizational test for exempt status is often incompatible with the state's business corporation laws created to govern a professional corporation. Acknowledging this tension, the Issue Snapshot states that the organizational language of the entity seeking exemption should not be contrary to or incompatible with the language or intent of applicable state law. Thus, the IRS has historically looked to other governing documents, such as the physician professional corporation's by-laws, to ensure that the requirements of the organizational test are being met.

The current PLR appears to focus narrowly on the language in the professional corporation's formation or incorporation document rather than the IRS's historical approach of looking comprehensively at all of the corporation's documents, including the incorporation document, by-laws and applicable shareholder agreement, to determine if the organizational test has been met. Whether this interpretation indicates a shift in the IRS's analysis of the corporate practice of medicine proscription generally or is an isolated departure remains unclear at this point, but the ruling seems to be a departure from the IRS's historical review of physician professional corporations that seek tax-exempt status under Section 501(c)(3).

Physician professional corporations that have been formed in jurisdictions that adhere to the corporation practice of medicine proscription and that included language necessary to meet the organizational test of Reg. Section 1.501(c)(3)-1(a)(1) in documents other than the incorporation document should closely monitor any relevant future guidance that results from the determination in this PLR to assess the impact on either their existing, or any pending, tax-exempt status under Section 501(c)(3).

———————————————