The Tax Court held that a surgeon properly classified as passive his income from a limited liability company (LLC) interest in an outpatient surgery center.
Facts: The taxpayer, Stephen Hardy, was a plastic surgeon who performed surgeries at various facilities, including his own office. Hardy operated his practice as a single-member professional LLC. He purchased a minority interest in an existing LLC, Missoula Bone & Joint Surgery Center (MBJ) that owned and operated a surgery center to accommodate procedures not requiring overnight hospitalization. The center was owned by various physicians who were not engaged in a common medical practice. It was professionally managed, had its own employees, and billed patients separately for its services. Hardy's income from the center was not determined by the number of procedures he performed there. For 2008 through 2010, Hardy's CPA tax preparer determined that the income from MBJ was passive rather than active. In prior years, the preparer, relying on the characterization of the income on the Forms K-1, Partner's Share of Income, Deductions, Credits, etc., furnished by MBJ, treated Hardy's distributive share of income as active income subject to self-employment taxes. In 2006 and 2007, Hardy had passive losses from unrelated rental activities that, due to a lack of passive income, could not be deducted under the passive loss limitations of Sec. 469. After the tax preparer learned that Hardy was not involved in managing MBJ and was not liable for its debts, he determined that Hardy's income from MBJ was from a passive activity. Hardy's tax returns for 2008—2010 netted his passive income against his passive losses, which included the passive loss carryovers from 2006 and 2007, reducing Hardy's income by over $250,000. The IRS, asserting that the income was active in nature, proposed a deficiency.
Issue: The issue presented in the case was whether the surgery center was a passive activity with respect to Hardy or whether it was required to be grouped with his medical practice and treated as a nonpassive activity. Resolution of the issue involved consideration of the passive loss limitations of Sec. 469 and application of the activity grouping rules in the Sec. 469 regulations.
Holding: The Tax Court determined that Hardy's ownership interest in the surgery center was a passive activity and that the IRS did not have sufficient grounds to group the surgery center with the medical practice. The tax preparer had not previously grouped MBJ with the medical practice by treating it as a nonpassive activity so as to require regrouping. In addition, Hardy was not involved in managing the center or in practice with the other investor doctors, and his income from the center was not determined by the number of procedures he performed at the facility. Distinguishing Renkemeyer, Campbell & Weaver, LLP, 136 T.C. 137 (2011), the court found that Hardy's income from MBJ was derived through his investor status. Consequently, applying the factors for grouping activities as an appropriate economic unit in Regs. Sec. 1.469-4(c)(2), it determined that treating the surgery center and the medical practice as separate economic activities was reasonable. The court distinguished facts of the case from those in the grouping example in Regs. Sec. 1.469-4(f), where a physician's practice group improperly attempted to divide its medical practice into active and passive activities by setting up an X-ray facility to provide services to its patients. In the example, the facility was established for the purpose of providing passive income to offset passive tax shelter losses, and the services were provided to each doctor's patients in the proportion of the doctors' ownership interests. The grouping in the example is not appropriate because the activities are not separate economic units. On the other hand, the Tax Court stated, the case was virtually identical to Technical Advice Memorandum 201634022, in which a physician properly treated as passive an interest in an LLC surgery center.
However, Hardy's success on this issue did not end up yielding the results he desired. The Tax Court also held that Hardy had no passive loss carryforwards from 2006 and 2007 available to offset passive income for 2008—2010. The court found that had Hardy properly treated the surgery center income as passive in the closed years of 2006 and 2007, the passive losses for those years would have been absorbed, leaving no carryforward. Hardy raised in his opening brief the argument that the doctrine of equitable recoupment would permit offset of taxes mistakenly paid in 2006 and 2007. However, the court did not address this interesting question, finding that because the IRS did not have notice of argument before trial, Hardy had not timely raised the argument. Consequently, Hardy was only able to recover self-employment taxes he overpaid in 2008 and 2009 on the income from MBJ.
- Hardy, T.C. Memo. 2017-16
—By Keith Kebodeaux, J.D., LL.M., a clinical assistant professor of accounting at Texas State University—San Marcos in San Marcos, Texas.