Greetings from Haoshen Zhong.
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This week’s newsletter topic came by way of a CPA I will call SL.
I have a client who is a US citizen and a physician, running a practice through a Canadian corporation. She owns 50% of the shares of the corporation, and her brother owns the other 50%. Her brother is a Canadian citizen and a nonresident alien. The corporation earns all its income from medical services. It owns some chairs, computers, medical implements, etc, but most of its assets are cash. The individual doctors’ goodwill constitute a very small portion of the worth of the corporation. Is this a PFIC?
In this newsletter, we will take a look at how the income and and assets of the medical practice is classified to determine whether the practice is a PFIC, despite obviously being an active business.
A passive foreign investment company (PFIC) is a foreign corporation that meets either 1 of the following 2 tests (IRC §1297(a)):
A Canadian corporation is a foreign corporation, because it is not organized in the US, under US laws, or under a US state law. IRC §7701(a)(4). Therefore, if this Canadian corporation meets either the income test or the asset test, then it is a PFIC.
Almost all income of this Canadian corporation is from medical services, so it would certainly seem that the corporation does not meet the income test. But unfortunately, the way passive income is defined makes it possible that this type of personal service company has passive income.
Passive income is “any income of a kind which would be foreign personal holding company income as defined in section 954(c)”. IRC §1297(b)(1). As it happens, foreign personal holding company income includes the following:
(H) Personal service contracts
(i) Amounts received under a contract under which the corporation is to furnish personal services if–
(I) some person other than the corporation has the right to designate (by name or by description) the individual who is to perform the services, or
(II) the individual who is to perform the services is designated (by name or by description) in the contract, and
(ii) amounts received from the sale or other disposition of such a contract.
This subparagraph shall apply with respect to amounts received for services under a particular contract only if at some time during the taxable year 20 percent or more in value of the outstanding stock of the corporation is owned, directly or indirectly, by or for the individual who has performed, is to perform, or may be designated (by name or description) as the one to perform, such services. IRC §954(c)(1)(H).
This is a very unexpected and unfortunate result of Congress choosing to define passive income by reference to foreign personal holding company income, because the foreign personal holding company income rules exist to prevent deferral of US tax using a foreign corporation, not convert active business income to passive income. Certainly payment for personal services would normally be considered income from an active business.
But Congress chose to define passive income in a way that includes income from personal service contracts. Here, the US doctor and the Canadian doctor both own more than 20% of the shares of the Canadian corporation. Thus, if the service contracts designates a doctor, or the patient has the right to designate the doctor, then the service income would be passive income.
We do not actually know the terms under which this corporation provides services. For many types of medical services, the patient-doctor relationship is a deeply personal one, so the corporation may not be permitted to change the doctor without the patient’s consent. Canadian law may have something to say on this subject, but I do not know what that is.
Without knowing how Canadian law governs contracts for medical services and without knowing how this corporation writes its medical service contracts, it is difficult to say if the income from medical services is passive income. But we should be mindful that it is possible for the income of this practice to be passive income–despite the fact that the medical practice is obviously an active business.
Passive assets are those that produce passive income or are held for the production of passive income. IRC §1297(a)(2).
Cash is a passive asset. Notice 88-22; 1988-1 CB 489. This is not surprising, because cash only produces interest, and interest is a type of passive income. IRC §954(c)(1)(A). We are told that the chairs, computers, medical implements, and goodwill that the corporation owns are worth very little compared to its cash, so it seems that the corporation has more than 50% passive assets.
There is one potential way out of meeting the asset test:
Any tangible personal property with respect to which a foreign corporation is the lessee under a lease with a term of at least 12 months shall be treated as an asset actually held by such corporation. IRC §1297(d)(1).
This rule might provide the practice with a way out of the asset test, because some medical practices lease very expensive equipment.
The amount that the leased asset is worth is “the unamortized portion (as determined under regulations prescribed by the Secretary) of the present value of the payments under the lease for the use of such property”. IRC §1298(d)(2)(A). The discount interest rate is the applicable federal rate that would be in effect for a loan of the same duration as the least term. IRC §1298(d)(2)(B).
What this more or less says is to do the following for a lease of a physical item for which the total lease term is at least 12 months:
If this corporation leases a significant quantity of expensive medical equipment, then it is possible that the value of the leased equipment would be greater than the cash it has in reserve. There is some potential that this corporation does not in fact meet the asset test.
For a personal service company, look at the company’s contracts. If the contracts designate the employee who will perform services, or if the client can designate the employee, then the personal service income is actually passive income.
Leased equipment contributes to the value of the nonpassive assets. For a corporation that leases a significant quantity of equipment, it can be worth valuing the equipment to see if the corporation can avoid becoming a PFIC under the asset test, even if it holds a lot of cash.
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