IRS Risks & Section 1060 Compliance

Buy-in arrangements for new physician partners have long been a common vehicle for medical and dental practice transitions. These structures traditionally involve a modest stock purchase combined with reduced compensation over time. While historically accepted, recent scrutiny under Internal Revenue Code Section 1060 and related case law has introduced significant tax risk.

This post explores the IRS concerns with traditional buy-in structures and how practices can better align their arrangements with current tax law.

The Core Tax Problem

A standard buy-in often involves:

A discounted purchase price for stock, and

Reduced compensation (income “discounting”) to account for goodwill and accounts receivable.

The IRS may challenge this structure in two primary ways:

1. Recharacterization as a Disguised Stock Purchase

The IRS may argue that reduced compensation is actually apayment for equity, effectively increasing the purchase price of the stock.

2. Recharacterization as Corporate Profit

Alternatively, the IRS may assert that the “discounted” income is actually corporate profit that should have been taxed at the entity level and distributed as dividends.

Why the Pediatric Surgical Associates Case Matters:

In the 2001 case of Pediatric Surgical Associates, P.C. v. Commissioner, the Tax Court addressed a compensation structure used by a medical professional corporation that attempted to significantly reduce its taxable income at the corporate level. The practice paid its physician-shareholders nearly all of the corporation's earnings in the form of compensation and bonuses, leaving little to no taxable corporate profit. The IRS challenged this approach, arguing that a portion of those payments represented corporate earnings rather than reasonable compensation for services rendered.

The Tax Court agreed with the IRS in part, holding that although physician-shareholders are entitled to compensation for their services, the amounts paid must still meet the standard of “reasonable compensation” under Internal Revenue Code § 162. The court closely examined the structure and found that certain payments exceeded what would be considered reasonable compensation for the services performed and were instead properly characterized as distributions of corporate profit. As a result, those amounts were reclassified, leading to additional corporate-level tax liability.

Importantly, the case underscores that even in closely held professional corporations—where physicians both generate revenue and control compensation decisions—the IRS will look beyond labels and examine whether payments reflect true compensation or disguised distributions of profit. The court evaluated multiple factors, including the services performed, the relationship between compensation and productivity, and whether the structure had the effect of eliminating corporate taxable income.

This case highlights a key risk:  Compensation structures that deviate from economic reality—or that are designed primarily to minimize taxes rather than reflect fair market value for services—may be reclassified by the IRS, resulting in unexpected tax exposure at both the corporate and shareholder levels.

Section 1060: Why It Matters

Section 1060 applies toapplicable asset acquisitions, requiring parties to allocate purchase price among assets using the residual method.²

Key implications for medical practices:

• Goodwill and accounts receivable must be properly valued

• Both buyer and seller must report consistent allocations

• Related agreements (e.g., compensation arrangements) may be scrutinized together

Additionally, Treasury Regulations require reporting of certain transactions viaForm 8594, increasing transparency and audit risk.³

Practical Takeaways for Healthcare Practices

To mitigate IRS risk:

• Ensure compensation reflects fair market value (FMV) for services

• Avoid tying compensation reductions directly to stock acquisition

• Maintain clear documentation of valuation methodologies

• Align agreements with economic substance—not just form

Need Help Structuring Your Medical or Dental Transition?

Practice transitions including buy-in models must be carefully structured to withstand IRS scrutiny.  A well-documented, economically grounded approach is essential to avoid unintended tax consequences.

If you are planning to transition a medical, dental, chiropractic, physical therapy, pharmacy, or other healthcare corporation in California, West Coast Health Law Group can provide clear guidance for your practice.  We offer a FREE consultation with West Coast Health Law Group which you may schedule by clicking the button on our website..

References

1. Pediatric Surgical Associates, P.C. v. Commissioner, 81 T.C.M. (CCH) 1474 (2001).

2. Internal Revenue Code § 1060.

3. Treas. Reg. § 1.1060-1; IRS Form 8594 Instructions.