Surgical Center Interest Was Separate from Surgeon’s Practice

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The Tax Court ruled, on January 17, 2017 in Tax Court Memo 2017-16, in favor of a surgeon who operated his professional medical practice (“Practice”) as a sole practitioner (“Physician”) and also held a minority interest in a limited liability company that operated a surgical center (“LLC”).

The Tax Court held that the surgical center was a passive activity and that the Internal Revenue Service (“IRS”) was not justified in determining that the surgeon’s income from the limited liability company was nonpassive and grouped with his medical practice income under Internal Revenue Code (“IRC”) §469.

Passive v. Nonpassive Activities

Under IRC §469, a passive activity is an activity which involves the conduct of any trade or business in which the taxpayer does not materially participate. Passive losses may only be offset by passive income. For example, rental real estate is generally considered a passive activity. A loss from a rental real estate activity may not be used to offset income from any other activity in which a taxpayer materially participates; such as income from employment.

Under Treasury Regulation §1.469-4(c)(1), a taxpayer may group or treat one or more trades or businesses as a single activity if the activities are an appropriate “economic unit” for the measurement of gain or loss for the purposes of the passive activity rules. There are five overriding factors that the IRS focuses on when deciding whether or not to group activities:

  1. Similarities and differences in types of businesses;
  2. The extent of commercial control;
  3. The extent of commercial ownership;
  4. Geographic location; and
  5. Interdependencies between or among the activities.

It is important to note that, in determining whether or not activities should be grouped, not all five of the above requirements must be met.


The Physician is the sole proprietor of the Practice. Because of limited availability, the Physician struggled to obtain space at a hospital for his procedures. LLC is a limited liability company taxed as a partnership which was previously formed by a group of physicians to operate a surgical center. LLC is professionally managed, has its own employees and bills its patients for the use of its facility.

In 2006, Physician purchased a 12.5% membership interest in LLC and became a member in LLC with seven other physicians. He never managed LLC nor did his Practice share employees with LLC. Physician also received distributions from LLC, which were not dependent on the number of surgeries performed at the facility.

For 2006 and 2007, the Physician and his spouse, in filing a joint personal income tax return, reported income from LLC as nonpassive based on how the income was reflected on the Physician’s Form K-1 received from LLC. Accordingly, the income from LLC was not grouped with the income from the Practice. The certified public accountant (“CPA”) that prepared the Physician’s personal income tax return did not consider the grouping regulations under IRC §469.

When Physician and his spouse filed their personal income tax returns for the 2008 through 2010 years, the income from LLC was treated as passive due to the fact that their CPA determined that Physician did not actively participate in the management of LLC, nor was he liable for any of the debt of LLC. In preparing their personal income tax returns for 2008 through 2010, the CPA utilized existing passive activity losses to offset the income generated from LLC as a passive activity.

The IRS audited the Physician’s personal income tax returns for 2008 through 2010. To be consistent with the way the income from LLC was treated in 2006 and 2007,  the IRS grouped Physician’s income from Practice with the income from LLC as a single economic unit. By treating the income from LLC as nonpassive in 2006 and 2007, the IRS argued that the Physician grouped the Practice income with that of LLC. Accordingly, the IRS disallowed the passive losses for the years audited and determined that grouping the activities precluded the Physician from changing the grouping for the 2008 through 2010 years.

The Tax Court Decision

The Tax Court disagreed with the IRS’ conclusion that Physician grouped the income from LLC with the income from the Practice when LLC was treated as nonpassive. In order to group activities, an election statement must be attached to the tax return. Such an election statement was never filed or considered by the Physician’s CPA when preparing and filing the Physician’s personal income tax return for the 2006 year.

The Tax Court cited the following in its decision:

  1. Physician held a minority interest in LLC which resulted in a lack of common control between LLC and his medical practice;
  2. LLC is a surgical center providing a facility for surgeries. Physician was a surgeon. Both are medically related; however, there are clear differences in each of the businesses;
  3. LLC charges patients a separate facility fee and Physician bills separately for his medical services;
  4. LLC has its own employees.
  5. Physician is the sole owner of the Practice which has its own employees.
  6. LLC is separately and professionally managed from the Practice.


Based on the information and facts, the Tax Court decided that the IRS’ grouping of the activities was not justified.  Although all five factors in determining whether or not to group activities do not have to be met, the Tax Court believed that there was not enough sufficient evidence to justify grouping the activities.  Additionally, the Tax Court decided that treating the income from LLC as passive on the Physician’s 2008 through 2010 personal income tax returns was correct.  However, due to the fact that the Physician received distributions from LLC during 2006 and 2007, the Physician erroneously treated his income from LLC as nonpassive.  Accordingly, had the income been correctly reported as passive in 2006 and 2007, the passive losses generated would have been fully absorbed by the distributions received and, not available to offset passive income in future years.

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To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.


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