HEALTH
LAW REPORT
A Newsletter from the Health Care Law Practice Group
www.flastergreenberg.com
Physician-Shareholder Compensation Deduction may
be Disallowed if Attributable to Non-Shareholder
Employee Services
I
n order to take
advantage of
various employee
benefits for its key
employees, many
physician practices
are structured as a
so-called “C corpora-
tion”, rather then as an “S corporation”
or limited liability company (“LLC”).
While C corporation tax status requires
the corporation’s net income to be taxed
at the corporate level (rather than to its
shareholders, 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
In This Issue…
Physician-Shareholder
Compensation Deduction
May Be Disallowed If
Attributable to
Non-Shareholder
Employee Services ................1
Structuring Buy-Ins with
Taxes 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
Copyright © 2002
By Stephen M. Greenberg
nominal level by essentially paying all of
it out as compensation to the physician-
shareholders. Since such income is nor-
mally produced by the performance of
personal services, the payment of com-
pensation for those services has usually
been 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 be
deductible to the corporation if it repre-
sents profits generated by the services of
non-shareholder professional employees.
Pediatric Surgical Associates, P.C. v.
Editor’s Note…
This issue of Health
Law Report focuses on
financial and manage-
ment aspects of a health
care practitioner’s pro-
fessional practice. The
lead article explores the
potential negative tax
implications of a recent
Alma L. Saravia
U.S. Tax Court case on
practices that operate as
a “C” corporation. The last issue of Health
Law Report highlighted legislation, now fea-
tured in this issue as law, making New Jersey
the third state in the nation to allow physicians
and dentists to engage in joint negotiations
with managed care entities. Another new law
authorizes the New Jersey State Board of
Medical Examiners (B.M.E.) to mandate that
physicians must take 100 continuing medical
education courses over two years in order to
be a licensee in good standing with the B.M.E.
The number one health care topic being
discussed among physicians is medical mal-
Health Law Report • Flaster/Greenberg P.C.
Spring 2002
Commissioner, 81 T.C.M. 1474 ( 2001).
Since so–called “personal service corpora-
tions” are subject to Federal income tax
at the rate of 35% from their first dollar
of taxable income, professional practices
impacted by this case would have their
income taxed at combined Federal and
state income tax rates of almost 40%.
Pediatric Surgical Associates, P.C. was
a personal services corporation employing
both shareholder and non–shareholder
surgeons pursuant to employment agree-
ments between them and the corporation.
The employment agreements of the
(continued on page 2)
practice insurance. The Senate Health
Committee recently held a special hearing on
“the affordability and accessibility of medical
malpractice insurance.” Several carriers will no
longer write medical malpractice policies, and
the two main carriers remaining in New Jersey
are MIXX and Princeton Insurance Company.
A number of specialists have experienced sig-
nificant rate increases. The Health Committee
is 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 to
health care providers are flat or decreased, per-
sistent increases in overhead, from insurance
premium increases to added expenses in other
areas may lead some physicians to re-examine
their practice options.
Flaster/Greenberg attorneys represent
physicians and other health care providers at
the local, State and national level. We advo-
cate for changes in the laws and regulations
and work with you to structure your practice
in ways that contribute to maximizing income.
Please visit our web site or call any one of the
attorneys in our Health Care Practice Group
if you have a question about our services.
 2

Physician-Shareholder Compensation Deduction… (continued from page 1)

shareholder surgeons called for the payment of a base salary in the amount of Choice of Entity: The potential dis-
$16,500 per month and “cash bonuses in such amounts and at such times and on allowance of deductions for compensation
such basis as the Board of Directors may from time to time, in its absolute discretion, paid to physician-shareholders is a reason
determine.” The employment agreements of the non–shareholder surgeons provided to reconsider whether the C corporation
for a base salary of lesser amounts and did not provide for any bonus compensation. is the “entity of choice” for professional
In the middle of each month, the corporation would determine the amount necessary practices. While there may have been good
to meet its anticipated cash flow needs for the immediate and near term, subtract that reasons to organize professional practices
amount from the amount of cash in its bank account, and pay the balance, (if any), in as C corporations in the past, many of the
equal amounts to the shareholders in the form of bonuses, which the corporation then tax advantages of C corporations have
deducted in determining its taxable income. been eliminated, thus making the S corpo-
ration and limited liability company more
Citing Internal Revenue Code Section 162(a)(1), which allows a deduction “for
compelling alternatives. C corporations do
salaries or other compensation for personal services actually rendered,” the Court disallowed continue to offer the favorable tax benefits
the deduction of “bonuses” to the shareholder surgeons to the extent they represented of deductible life insurance plans under
“profits” attributable to the services rendered by the non–shareholder surgeons and Internal Revenue Code Sections 79 and
calculated these profits by subtracting an allocable share of the corporation’s overhead 419A(f)(6), and uninsured medical expense
from the actual collections attributable to each non-shareholder surgeon’s services. Its reimbursement plans and deductible
stated rationale was that such amounts were not “for services actually rendered” by the payment of disability insurance premiums
shareholder surgeons and, therefore, were not deductible. under Code Sections 105 and 106.
Observations: However, the tax benefits of fully deductible
health insurance premiums will become
◆ This decision could represent a “green light” for the IRS to now available in S corporations and limited
challenge the deductibility of bonuses, or even high salaries, paid liability companies as of January 1, 2003.
to physician-shareholders in professional corporations where a
Tax Planning Tip: Given the recent
portion of their compensation may be attributable to profits
Pediatric Surgical Associates, P.C. deci-
generated by non–shareholder employees.
sion, it may be appropriate to consider
◆ Although foreboding in its approach, this case presented a converting a professional practice from a
particularly egregious set of facts, and, therefore, may not have C corporation to an S corporation where
the broad impact that is feared. For example, it is never a good substantial profits are generated by the
idea to pay monthly bonuses to shareholders only, in an amount professional services of non–shareholders
equal to the corporation’s unencumbered cash balances. or from “technical revenues” attributable
◆ With some additional planning and more carefully drawn employment agreements, to certain diagnostic or therapeutic
it should be possible to establish that there are additional services provided by equipment and/or services. It should be
physician-shareholders that justify the payment of additional compensation. noted, however, that such a conversion
◆ It may be possible to justify additional deductible payments to physician-sharehold- will engender so–called “built–in gains”
ers by documenting that some portion of the amounts paid represents a measure of in an amount at least equal to the value
deferred compensation from the time when the non–shareholder employees were of the corporation’s accounts receivable,
and that will make such latent profits
paid salaries, but were not producing any revenue.
potentially taxable at the corporate level
◆ The recharacterization of shareholder compensation as dividends could have a for ten years from the conversion. Thus,
domino effect – e.g., potentially reducing the compensation base and hence the while an S election may solve this prob-
level of contribution and/or benefits for such physician-shareholders under the lem for the long term, careful planning
corporation’s 401(k), profit sharing or pension plans. and documentation will still be necessary
◆ There are a number of other planning techniques that can be implemented to to minimize tax at the corporate level for
minimize this exposure in appropriate situations. the interim period.

FLASTER/GREENBERG CELEBRATES 30 ANNIVERSARY TH

This report, published as a
AS SPONSOR OF 30 ANNUAL HEART DAY JUNE 5!
TH
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The 30th Annual Heart Day is part of an 8-week fund-raising event culmi- clients and interested readers, is
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for general use and information.
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its 30th year, is proud to partner with Heart Day as a Headline Corporate The content should not be inter-
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Health Law Report • Flaster/Greenberg P.C.

 3

Structuring Buy-Ins with Taxes in Mind

By Markley S. Roderick

W
hen a new
partner pur-
chases an
interest in an existing
practice, the parties
must negotiate the
price, the payment
schedule, and other
important terms and
conditions. In most respects, the interests
of the new partner and the interests of
the existing partners conflict – typically,
the new partner wants a lower price and
the existing partners want a higher price.
By structuring the buy-in to obtain the
maximum tax benefit, however, both
sides can benefit.
To illustrate the tax principles, sup-
pose that Dr. Smith, an associate with
Good Health Associates, P.C., is offered
the 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 Good
Health from Dr. Jones.
These are the Federal income tax con-
sequences of the stock purchase:
◆ Dr. Smith is in the highest Federal tax
bracket. 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 of
20%, or $50,000. He will therefore be
left with $200,000 when the dust set-
tles, after tax.
◆ To summarize: Dr. Smith earned
$400,000 to pay the buy-in price, but
Dr. Jones ended up with only half, or
$200,000, to spend. The other half
went to taxes.
Now suppose that the transaction is
restructured. The price of the stock is
reduced to $10,000, but the parties
agree that the compensation of Dr. Jones
over the next five years will be increased
by $70,000 per year, or $350,000, with
the compensation of Dr. Smith being
reduced by the same amount. The tax
consequences:
◆ Dr. Smith must earn about $16,000 to
pay Dr. Jones $10,000 for the stock.
She pays the other $6,000 in tax.
◆ Dr. Smith must earn only $350,000
to “pay” $350,000 of extra compen-
sation to Dr. Jones.
◆ Thus, Dr. Smith must earn $366,000
for the buy-in, rather than $400,000.
She saves $34,000, which translates to
approximately $21,000 after tax.
◆ Dr. Jones pays tax of approximately
$2,000 on his sale of stock, and
approximately $140,000 on his
“extra” 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 the
transaction, both Dr. Jones and Dr.
Smith are better off. Together, they
saved approximately $30,000 after tax,
equivalent to generating an extra
$46,000 of revenue within the practice.
Of course, the consequences of a
given transaction will depend on the tax
position of the individuals involved –
lower or higher brackets, state taxes, and
so forth. In addition, Dr. Smith in the
second example will take a “basis” of
only $10,000 in her stock, which could
theoretically increase her tax if the stock
is ever sold in the future. And the
$10,000 stated value for the stock has to
be fair under IRS standards.
Nevertheless, there is real money to be
saved by structuring healthcare buy-in
transactions 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 to Five Key Points to Know About

Negotiate with Managed Care the Joint Negotiations Law
Companies 1. It gives physicians the right to jointly negotiate,
through a representative they select, with carriers
By Alma L. Saravia on non-fee related matters, including patient referral
standards, drug formularies and clinical practice

T
hrough the efforts of the State’s physi-
cian community, New Jersey became
the third state in the nation to enact
joint negotiation legislation, effective as of
April 8, 2002. Texas and Washington were
the first two states to allow physicians the
right to collectively bargain. The law creates
an antitrust exemption, through state action
immunity, allowing physicians and dentists
to negotiate over fee and non-fee based
matters with managed care entities. In this new managed care
environment, patients will benefit, as well as physicians and den-
tists, who will be able to jointly negotiate with insurance carriers
and managed care entities over contractual terms and condi-
tions. Physicians’ ability to negotiate is critical to increasing
patient access to better health care.
guidelines.
2. Physicians are allowed to negotiate with carriers on
fee matters as long as the New Jersey Attorney
General has ruled that the carrier has substantial
market power and its contract terms and conditions
could hurt patient care.
3. Physicians are required to submit a joint negotiations
petition to the Attorney General and pay a filing fee.
The results of any joint negotiations agreements are
also subject to the Attorney General’s approval.
4. The law bars physicians from striking.
5. The law does not require carriers to join physicians at
the negotiations table.

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