Tax Court Says Surgical Center Income Was Passive

Do you have physician clients who own a facility where they practice or perform surgery? If the physician doesn’t “materially participate” in the management of the building, the income may be treated as passive activity income under the tax law. Conversely, the activities may be grouped to rise to the level of material participation. That was the issue presented to the Tax Court in a new case (Hardy, TC Memo, 2017-16, 1/4/17).

Usually, income from passive activities, like investment real estate, can only be offset by expenses from passive activities. A passive activity is generally one in which the taxpayer does not materially participate. Any excess passive activity loss for the year is suspended and may be used to absorb passive income in a subsequent year. Other special rules may provide a partial write-off for active participants in rental real estate.

In the new case at hand, the taxpayer, a plastic surgeon specializing in pediatric reconstructive surgery, operated on patients in his office and in some local hospitals. He was finding it difficult to obtain space at the local hospitals. To help solve this problem, the taxpayer invested in a surgery center where he could perform procedures.

The taxpayer held a 12.5% interest in the surgery center. He never managed the facility and had no day-to-day responsibilities there. Although he regularly meets with the other members, he does not have any input into management decisions. He generally is not involved in hiring or firing decisions.

Although he performs surgeries at the center on Mondays, the taxpayer rarely operates there in other days of the week. He doesn’t pay rent to perform surgeries at the facility and the patients pay the facility fees directly.

On his 2007 return, the taxpayer showed excess passive losses. After initially claiming that he materially participated in the surgery center, based on guidance from a tax professional, he reported the opposite on his return. Instead, he said that his interactions were simply as an investor and a provider making use of the center on the same terms as non-owner surgeons.

But the IRS challenged that the assertion that the surgery center income the surgeon received constituted passive income. It relied on two theories that this physician was a material participant in the activity.

1. It argued that he had first reported the income as material participation income and thus had grouped the surgery center with his medical practice for these purposes.

2. The IRS said that, in any event, the only valid “appropriate economic unit” for grouping purposes under the regulation was to combine the surgery center activity with the medical practice.

But the Tax Court shot down the IRS’ arguments. First, the Court rejected the point of view that the reporting of the activity as a material participation activity constituted a grouping with the surgical practice in those years. The Court noted the tax professional testified that he had relied on Form K-1 information for the year in question to determine the taxpayer was materially participating and had not made the determination based on grouping the activities under the regulations.

The taxpayer never explicitly stated that he had grouped the activities. Under the prevailing law, he was not required to do so.

Second, the Tax Court determined that the IRS did not meet the requirements for regrouping the surgery center and medical practice as an appropriate economic unit. As a result, based on all the facts and circumstances, the taxpayer is able to treat the surgery center income as passive income.

It’s important to know what side of this issue your physician clients come down on. Consider the outcome in this case as it pertains to other situations.