Commentary: Avoid putting client's tax-qualified retirement plans in

Suppose you help your client's medical practice open a one-room surgery center with two other nearby medical practices. All three medical practices are otherwise completely unrelated, and each practice owns one-third of the new facility. Would you be surprised to find out that you may have just put the tax qualification of the retirement plans of each of the practices in jeopardy?

Many health care professionals maintain a tax-qualified retirement plan as part of their practice. However, if a retirement plan loses its tax-qualification, then: (1) contributions to the plan may not be currently deductible; (2) the plan's investment earnings become taxable; and (3) owners covered by the plan may have to pay taxes on their retirement benefits before they receive them.

Among many other Internal Revenue code requirements, a tax- qualified retirement plan must cover a minimum percentage - generally 70 percent - of all of the practice's employees.

This minimum coverage test calculates the percentage of employees who are covered by a retirement plan by counting all employees (including leased employees) of the practice, as well as the employees of companies controlled by, or affiliated with, the practice.

In general, another company is controlled by the practice if it is 80 percent or more owned by the practice, or 80 percent or more owned by the owners of the practice.

A little known provision of the Internal Revenue code - called the affiliated service group rules - sets forth the principles used to determine when companies are affiliated for coverage test purposes.

These affiliated service group rules are quite complex. Most troublesome is one section that provides that an affiliated service group may exist when two service organizations have some common ownership and both regularly provide service together, which is arguably the case with surgeons and surgery centers.

For example, if the employees of a surgery center do not have a retirement plan, while each of the center's surgeon owners has a retirement plan, then the tax qualification of the retirement plans of the surgeon owners could be in jeopardy.

Moreover, the affiliated service group rules may not only cause a surgeon owner's practice to be deemed affiliated with the surgery center, but all of the practices of all of the surgeons owning an interest in the center may also be deemed affiliated with each other. Therefore, even if the surgery center's employees have a retirement plan that is comparable to the plan of one surgeon owner, all of the participants' retirement plans might still be at risk because another surgeon owner has no retirement plan or a particularly rich retirement plan.

Some commentators have argued that surgery centers are so capital intensive that they should not be considered a service provider in the first place, and therefore the affiliated service group rules may not be applicable. Unfortunately, there is no guidance from the IRS confirming this logic.

There are also ways to structure the relationships between parties to avoid creating an affiliated service group. For example, forming the surgical center as a regular corporation, instead of an LLC or a partnership, may help. In fact, surgery centers formed as LLCs may want to consider transitioning their structure from an LLC to a regular corporation and then electing S status. The conversion to a regular corporation may avoid the affiliated service group problem, if there is one, and the S status election will continue the LLC's favorable tax treatment.

If an affiliated service group cannot be avoided with certainty, there are alternative testing procedures that might be used to save the tax-qualification of the retirement plans. However, these alternative tests often require expensive actuarial calculations and there is no guaranty of success. Moreover, these alternative tests only come in handy when someone knows that an affiliated service group exists, and sees to it that the alternative tests are performed.

Ironically, there has been so little enforcement of the affiliated service rules that many have been lulled into ignoring them. Such behavior may also be due to the rules having been proposed in 1983, and remaining in proposed form through this writing. This means that complying with the proposed regulations protects a taxpayer, while violating them puts the taxpayer at risk.

The bottom line is that any time a practice owns (or is considering acquiring) an interest, no matter how small, in another health care operation, it is prudent to determine if an affiliated service group exists or will be created.

Barry F. Rosen is chairman and chief executive of the law firm of Gordon, Feinblatt, Rothman, Hoffberger & Hollander LLC. He can be reached at 410-576-4224 or [email protected]. Matthew P. Mellin is a member of Gordon, Feinblatt's employment law and employee benefits practice group, and he can be reached at 410-576-4047 or [email protected].

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