HealthLaw 02spring

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Editors NoteThis issue ofHealth

Law Reportfocuses onfinancial and manage-ment aspects of a healthcare practitioners pro-fessional practice. Thelead article explores thepotential negative taximplications of a recentU.S. Tax Court case onpractices that operate as

a C corporation. The last issue ofHealthLaw Reporthighlighted legislation, now fea-tured in this issue as law, making New Jerseythe third state in the nation to allow physiciansand dentists to engage in joint negotiations

with managed care entities. Another new lawauthorizes the New Jersey State Board ofMedical Examiners (B.M.E.) to mandate thatphysicians must take 100 continuing medicaleducation courses over two years in order tobe a licensee in good standing with the B.M.E.

The number one health care topic beingdiscussed among physicians is medical mal-

practice insurance. The Senate HealthCommittee recently held a special hearing onthe affordability and accessibility of medicalmalpractice insurance. Several carriers will nolonger write medical malpractice policies, andthe two main carriers remaining in New Jerseyare MIXX and Princeton Insurance Company.

A number of specialists have experienced sig-nificant rate increases. The Health Committeeis investigating the cause of these increases as

well as what remedial action it can take to sta-bilize the market. In an era when fees paid tohealth care providers are flat or decreased, per-sistent increases in overhead, from insurance

premium increases to added expenses in otherareas may lead some physicians to re-examinetheir practice options.

Flaster/Greenberg attorneys representphysicians and other health care providers atthe local, State and national level. We advo-cate for changes in the laws and regulationsand work with you to structure your practicein ways that contribute to maximizing income.Please visit our web site or call any one of theattorneys in our Health Care Practice Groupif you have a question about our services.

Alma L. Saravia

Physician-Shareholder Compensation Deduction maybe Disallowed if Attributable to Non-ShareholderEmployee Services By Stephen M. Greenberg

Copyright 2002 Health Law Report Flaster/Greenberg P.C

www.flastergreenberg.com Spring 2002

HEALTHLAWREPORTA Newsletter from the Health Care Law Practice Group

HEALTHLAWREPORTA Newsletter from the Health Care Law Practice Group

In This IssuePhysician-Shareholder

Compensation Deduction

May Be Disallowed If

Attributable to

Non-Shareholder

Employee Services................1

Structuring Buy-Ins withTaxes in Mind ......................3

NJ Physicians Win Right to

Negotiate with Managed

Care Companies ..................3

Five Key Points to Know

About the Joint

Negotiations Law ................3

I

n order to take

advantage of

various employeebenefits for its keyemployees, manyphysician practicesare structured as aso-called C corpora-

tion, rather then as an S corporationor limited liability company (LLC).

While C corporation tax status requiresthe corporations net income to be taxedat the corporate level (rather than to itsshareholders, as in the case of an S corpo-ration or members, as in the case of an

LLC), net income is usually kept at a

nominal level by essentially paying all ofit out as compensation to the physician-

shareholders. Since such income is nor-mally produced by the performance ofpersonal services, the payment of com-pensation for those services has usuallybeen considered deductible to the corpo-ration as an ordinary and necessary busi-ness expense. However, a recent U.S.Tax Court case has threatened to under-cut such traditional tax planning, in hold-ing that such compensation may not bedeductible to the corporation if it repre-sents profits generated by the services ofnon-shareholder professional employees.

Pediatric Surgical Associates, P.C. v.

Commissioner, 81 T.C.M. 1474 ( 2001).Since socalled personal service corpora-

tions are subject to Federal income taxat the rate of 35% from their first dollarof taxable income, professional practicesimpacted by this case would have theirincome taxed at combined Federal andstate income tax rates of almost 40%.

Pediatric Surgical Associates, P.C. wasa personal services corporation employingboth shareholder and nonshareholdersurgeons pursuant to employment agree-ments between them and the corporationThe employment agreements of the

(continued on page 2)


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shareholder surgeons called for the payment of a base salary in the amount of$16,500 per month and cash bonuses in such amounts and at such times and onsuch basis as the Board of Directors may from time to time, in its absolute discretion,determine. The employment agreements of the nonshareholder surgeons providedfor a base salary of lesser amounts and did not provide for any bonus compensation.

In the middle of each month, the corporation would determine the amount necessaryto meet its anticipated cash flow needs for the immediate and near term, subtract thatamount from the amount of cash in its bank account, and pay the balance, (if any), inequal amounts to the shareholders in the form of bonuses, which the corporation thendeducted in determining its taxable income.

Citing Internal Revenue Code Section 162(a)(1), which allows a deduction forsalaries or other compensation for personal services actually rendered,the Court disallowedthe deduction of bonuses to the shareholder surgeons to the extent they representedprofits attributable to the services rendered by the nonshareholder surgeons andcalculated these profits by subtracting an allocable share of the corporations overheadfrom the actual collections attributable to each non-shareholder surgeons services. Itsstated rationale was that such amounts were not for services actually rendered by theshareholder surgeons and, therefore, were not deductible.

Observations: This decision could represent a green light for the IRS to now

challenge the deductibility of bonuses, or even high salaries, paidto physician-shareholders in professional corporations where aportion of their compensation may be attributable to profitsgenerated by nonshareholder employees.

Although foreboding in its approach, this case presented aparticularly egregious set of facts, and, therefore, may not havethe broad impact that is feared. For example, it is never a goodidea to pay monthly bonuses to shareholders only, in an amountequal to the corporations unencumbered cash balances.

With some additional planning and more carefully drawn employment agreements,

it should be possible to establish that there are additional services provided byphysician-shareholders that justify the payment of additional compensation.

It may be possible to justify additional deductible payments to physician-sharehold-ers by documenting that some portion of the amounts paid represents a measure ofdeferred compensation from the time when the nonshareholder employees werepaid salaries, but were not producing any revenue.

The recharacterization of shareholder compensation as dividends could have adomino effect e.g., potentially reducing the compensation base and hence thelevel of contribution and/or benefits for such physician-shareholders under thecorporations 401(k), profit sharing or pension plans.

There are a number of other planning techniques that can be implemented tominimize this exposure in appropriate situations.

2

Health Law Report Flaster/Greenberg P.C.

Choice of Entity: The potential dis-allowance of deductions for compensationpaid to physician-shareholders is a reasonto reconsider whether the C corporationis the entity of choice for professional

practices. While there may have been goodreasons to organize professional practicesas C corporations in the past, many of thetax advantages of C corporations havebeen eliminated, thus making the S corporation and limited liability company morecompelling alternatives. C corporations docontinue to offer the favorable tax benefitsof deductible life insurance plans underInternal Revenue Code Sections 79 and419A(f)(6), and uninsured medical expensereimbursement plans and deductiblepayment of disability insurance premiumsunder Code Sections 105 and 106.However, the tax benefits of fully deductiblehealth insurance premiums will becomeavailable in S corporations and limitedliability companies as of January 1, 2003.

Tax Planning Tip: Given the recentPediatric Surgical Associates, P.C. deci-sion, it may be appropriate to considerconverting a professional practice from aC corporation to an S corporation wheresubstantial profits are generated by theprofessional services of nonshareholdersor from technical revenues attributableto certain diagnostic or therapeutic

equipment and/or services. It should benoted, however, that such a conversion

will engender socalled builtin gainsin an amount at least equal to the valueof the corporations accounts receivable,and that will make such latent profitspotentially taxable at the corporate levelfor ten years from the conversion. Thus,

while an S election may solve this prob-lem for the long term, careful planningand documentation will still be necessaryto minimize tax at the corporate level forthe interim period.

Physician-Shareholder Compensation Deduction (continued from page 1)

This report, published as a

service to Flaster/Greenberg

clients and interested readers, is

for general use and information.

The content should not be inter-

preted as rendering legal advice

on any specific matter.

FLASTER/GREENBERG CELEBRATES 30TH ANNIVERSARYAS SPONSOR OF 30TH ANNUAL HEART DAY JUNE 5!

The 30th Annual Heart Day is part of an 8-week fund-raising event culmi-nating on Wednesday, June 5 at Ponzios Restaurant in Cherry Hill, to benefitthe American Heart Association. Flaster/Greenberg, which is also celebratingits 30th year, is proud to partner with Heart Day as a Headline CorporateSponsor to help raise awareness of health issues and preventive actions for those

who are susceptible to cardiovascular disease. For more information, visit theHeart Day web site at www.heartday.org


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www.flastergreenberg.co

3

Structuring Buy-Ins with Taxes in MindBy Markley S. Roderick

When a newpartner pur-chases an

interest in an existingpractice, the partiesmust negotiate theprice, the paymentschedule, and otherimportant terms and

conditions. In most respects, the interestsof the new partner and the interests ofthe existing partners conflict typically,the new partner wants a lower price andthe existing partners want a higher price.By structuring the buy-in to obtain themaximum tax benefit, however, bothsides can benefit.

To illustrate the tax principles, sup-pose that Dr. Smith, an associate withGood Health Associates, P.C., is offeredthe opportunity to purchase a 50% inter-est in the practice by its current owner,Dr. Jones, for a purchase price of$250,000. The transaction will be struc-tured as a purchase of stock, where Dr.Smith buys half the stock of GoodHealth from Dr. Jones.

These are the Federal income tax con-sequences of the stock purchase:

Dr. Smith is in the highest Federal taxbracket. To earn the $250,000 to pay

Dr. Jones, she must earn approximately$400,000.

When Dr. Jones receives the

$250,000 purchase price from Dr.Smith, he will pay a capital gain tax of20%, or $50,000. He will therefore beleft with $200,000 when the dust set-tles, after tax.

To summarize: Dr. Smith earned$400,000 to pay the buy-in price, butDr. Jones ended up with only half, or$200,000, to spend. The other half

went to taxes.

Now suppose that the transaction isrestructured. The price of the stock isreduced to $10,000, but the partiesagree that the compensation of Dr. Jones

over the next five years will be increasedby $70,000 per year, or $350,000, withthe compensation of Dr. Smith beingreduced by the same amount. The taxconsequences:

Dr. Smith must earn about $16,000 topay Dr. Jones $10,000 for the stock.She pays the other $6,000 in tax.

Dr. Smith must earn only $350,000to pay $350,000 of extra compen-sation to Dr. Jones.

Thus, Dr. Smith must earn $366,000for the buy-in, rather than $400,000.

She saves $34,000, which translates toapproximately $21,000 after tax.

Dr. Jones pays tax of approximately

$2,000 on his sale of stock, andapproximately $140,000 on hisextra compensation of $350,000.He is left with $208,000 after tax, or$8,000 more than if he had sold stock

To summarize: by restructuring thetransaction, both Dr. Jones and Dr.Smith are better off. Together, theysaved approximately $30,000 after tax,equivalent to generating an extra$46,000 of revenue within the practice.

Of course, the consequences of agiven transaction will depend on the taxposition of the individuals involved

lower or higher brackets, state taxes, andso forth. In addition, Dr. Smith in thesecond example will take a basis ofonly $10,000 in her stock, which couldtheoretically increase her tax if the stockis ever sold in the future. And the$10,000 stated value for the stock has tobe fair under IRS standards.

Nevertheless, there is real money to besaved by structuring healthcare buy-intransactions with taxes in mind. After all,it is not how much you make that counts,but how much you make after tax.

NJ Physicians Win Right toNegotiate with Managed CareCompaniesBy Alma L. Saravia

T

hrough the efforts of the States physi-cian community, New Jersey became

the third state in the nation to enactjoint negotiation legislation, effective as ofApril 8, 2002. Texas and Washington werethe first two states to allow physicians theright to collectively bargain. The law createsan antitrust exemption, through state actionimmunity, allowing physicians and dentiststo negotiate over fee and non-fee based

matters with managed care entities. In this new managed careenvironment, patients will benefit, as well as physicians and den-tists, who will be able to jointly negotiate with insurance carriersand managed care entities over contractual terms and condi-tions. Physicians ability to negotiate is critical to increasingpatient access to better health care.

Five Key Points to Know Aboutthe Joint Negotiations Law

1. It gives physicians the right to jointly negotiate,through a representative they select, with carrierson non-fee related matters, including patient referralstandards, drug formularies and clinical practiceguidelines.

2. Physicians are allowed to negotiate with carriers onfee matters as long as the New Jersey AttorneyGeneral has ruled that the carrier has substantialmarket power and its contract terms and conditionscould hurt patient care.

3. Physicians are required to submit a joint negotiationspetition to the Attorney General and pay a filing fee.The results of any joint negotiations agreements arealso subject to the Attorney Generals approval.

4. The law bars physicians from striking.

5. The law does not require carriers to join physicians atthe negotiations table.


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Health Care LawPractice Group

Kristine M. ByrnesRichard J. FlasterKenneth S. GoodkindStephen M. Greenberg

Pasquale GugliettaMarkley S. RoderickSteven B. Sacharow

Alma L. SaraviaLaura B. Wallenstein

Alan H. Zuckerman

1810 Chapel Avenue WestCherry Hill, NJ 08002-4609

Visit our Web site at:www.flastergreenberg.com

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