A state medical school's faculty-practice entities are state instrumentalities for FICA and FUTA

Plain-English summary

A state university's medical school ran its clinical operations through two nonprofit entities: one that supports the medical school and its own wholly owned LLC that acts as the faculty practice plan and employs the doctors and staff. They asked the IRS to confirm they are wholly owned instrumentalities of the state for federal payroll-tax purposes. Applying the six-factor test of Rev. Rul. 57-128, the IRS ruled that both entities are state instrumentalities. That means, for Social Security (OASDI) tax, their employees' wages are covered only if the worker is not a qualified participant in a state retirement system; Medicare tax generally applies unless the pre-1986 continuing-employment exception fits; and, because the LLC is wholly owned by a 501(c)(3) organization, its wages are exempt from federal unemployment (FUTA) tax under § 3306(c)(8). The IRS gave no opinion on whether specific workers meet the retirement-system or continuing-employment exceptions.

Ruling snapshot

• Question: Are the university's two clinical entities wholly owned state instrumentalities, and how does that affect their FICA and FUTA liability?
• Outcome: Approved (both entities held to be state instrumentalities; FUTA exemption confirmed)
• Key authorities: IRC §§ 3121(b)(7), 3121(u)(2), 3306(c)(7)-(8); Treas. Reg. § 301.7701-2(c)(2)(iv); Rev. Rul. 57-128

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202102004 Third Party Communication: Private Firm
Release Date: 1/15/2021 Date of Communication: May 27, 2020
Index Number: 3121.00-00, 3121.02-00,
Person To Contact:
3121.02-05, 3121.15-00,
--------------------, ID No. -----------------
3306.00-00, 3306.03-00
Telephone Number:
--------------------

                                                           Refer Reply To:

                                                           CC:EEE:EOET:ET2

                                                           PLR-111059-20

                                                           Date:

                                                           October 21, 2020

Legend

State = ------
City = ---------
Organization 1 = -------------------------------------------------
Organization 2 = ---------------------------------------------------------------------
University = --------------------------
College M = ---------------------------------------------------------------------
Statute = ------------------------------------
Section A = ---------
Section B = ---------
M Center = ------------------------------------------------
Community = --------------------------------------------------------------------

Dear ------------:

This responds to your letter dated April 27, 2020, requesting a ruling on behalf of
Organization 1 and Organization 2 concerning their liabilities for taxes under the Federal
Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA).
Specifically, you have requested a ruling on the status of Organization 1 and Organization
2 as wholly-owned instrumentalities of State for purposes of sections 3306(c)(7) and
3121(b)(7) of the Internal Revenue Code (the Code).

Organization 2 received a letter from the Service recognizing that it is an organization
exempt from federal income tax under section 501(a) of the Code as an organization
described in section 501(c)(3). Organization 1 was organized by the University exclusively
for charitable, educational and scientific purposes within the meaning of section 501(c)(3)
PLR-111059-20 2

of the Code and for the benefit of, to perform the functions of, and to carry out the
purposes of University and its medical school, College M. University was created to be a
state university per Section A and Section B of the Statute. Further, it is represented that
University is a political subdivision of State.

Organization 2 was established to provide medical and health education to medical and
health science students, to pursue research in the health care and health service field
and to deliver medical and other health care services to the Community.

University is Organization 2’s sole member. Organization 2’s regulations specify that
University shall exercise its authority over Organization 2 through the following
individuals: (a) President of University; (b) Executive Vice President for Clinical Affairs
and Dean of College M; and (c) Three individual members of University’s Board of
Trustees. In addition, such regulations provide Organization 2’s actions are under the
supervision of its Board of Directors (the Board), which is composed of the following
individuals: (a) Dean of College M as the chairperson of the Board; (b) Chairperson of
each clinical department of College M; (c) Nine faculty members of College M; (d)
President of Organization 2 as an ex-officio voting member; and (e) Two additional ex-
officio non-voting members: the Executive Director of Organization 2 and the Executive
Director of the College M Hospitals. It is represented that all voting members of the Board
are employed by and under the direction and control of College M or University.

While the Board has authority to oversee Organization 2, Organization 2 is accountable
to University, through annual accountings submitted by the Board to University. Upon
Organization 2’s dissolution, its assets shall be distributed to University to the extent that
it is a political subdivision per section 115 of the Code. Otherwise, the assets shall be
conveyed to such organization as selected by the Board to the extent that such
organization is exempt from federal income taxation under section 501(c)(3) of the Code
or is a political subdivision per section 115 of the Code.

Organization 2 provides professional medical and related health care services through its
wholly-owned single member limited liability company, Organization 1. Organization 1 is
directly controlled by its manager, Organization 2, and indirectly controlled by University,
as Organization 2 is under the control of University.

Organization 1’s regulations specify that Organization 1 was organized for the benefit of,
to perform the function of, and to carry out the purposes of College M and Organization

2. Organization 1 acts as the Faculty Practice Plan for College M whereby members of
   the faculty at College M engage in the practice of medicine to the extent they hold a
   clinical faculty appointment at College M. Further, Organization 1 provides care and
   treatment to patients of the M Center, an unincorporated division of University, and to the
   Community.

Organization 1 employs all of the health care providers and, accordingly, controls the
compensation of such health care providers, including physicians, advanced practice
PLR-111059-20 3

providers, nurses, and support personnel with respect to clinical services. Organization
1’s regulations specify that its net earnings shall not inure to the benefit of any private
individuals or any director, trustee, officer, or employee of Organization 1.

Upon Organization 1’s dissolution, its assets shall be distributed to Organization 2, or to
another organization exempt from federal taxation under section 501(c)(3) of the Code
selected by Organization 2 in the event that Organization 2 is not qualified as exempt
under section 501(c)(3) at such time.

College M is affiliated with University, a state university and political subdivision of State,
chartered under the provisions of the laws of State. The statutes of State specifically
establish University and confer upon its trustees the power to employ such officers,
professors, teachers, and other employees as necessary. Further, Organization 1’s
Articles provide that only physicians and health professionals who have clinical faculty
appointments in College M are eligible to practice medicine as employees of Organization
1.

Law

Sections 3101 and 3111 of the Code impose FICA taxes on the wages paid by employers
to employees with respect to employment. Sections 3101(a) and 3111(a) impose Old-
Age, Survivors, and Disability Insurance (OASDI) taxes on the wages of employees.
Sections 3101(b) and 3111(b) impose Hospital Insurance (Medicare) taxes on the wages
of employees.

Section 3121(b)(7) provides that, for purposes of the FICA tax, “employment” does not
include service performed in the employ of a state, or any political subdivision thereof, or
any instrumentality of any one or more of the foregoing that is wholly-owned thereby.
Section 3121(b)(7)(F) of the Code and section 31.3121(b)(7)-2(c)(1) of the Treasury
Regulations provide that this exception does not apply to services performed after July 1,
1991, if the employee is not a “qualified participant” in a retirement system of the state,
political subdivision, or instrumentality.

Section 3121(u)(2) of the Code provides that, for services performed after March 31,
1986, section 3121(b)(7) does not relieve state and local government employers and
employees of liability for the Medicare portion of the FICA tax imposed by sections
3101(b) and 3111(b) of the Code. Generally, remuneration paid for services of an
employee of a state, local government, or one of their instrumentalities is subject to
Medicare taxes unless the continuing employment exception provided by section
3121(u)(2)(C) applies. Generally, the continuing employment exception from Medicare
taxation in section 3121(u)(2)(C) may apply if the employee has been continuously
employed by the same governmental entity and was performing services prior to April 1,
1986.
PLR-111059-20 4

Section 3301 imposes on every employer for each calendar year the tax under the FUTA
equal to a certain percentage of wages. Section 3306(b) provides that wages for FUTA
purposes means all remuneration for employment with certain specific exceptions.
Section 3306(c)(8) of the Code provides that, for purposes of the FUTA tax, “employment”
does not include service performed in the employ of an organization described in section
501(c)(3) and exempt from income tax under section 501(a).

Section 3306(c)(7) of the Code provides that, for purposes of the FUTA tax, “employment”
does not include service performed in the employ of a state, or any political subdivision
thereof, or any instrumentality of any one or more of the foregoing which is wholly owned
by one or more states or political subdivisions.

Under the check-the-box rules, an eligible entity that has a single owner (i.e., a “wholly
owned entity”) and isn’t treated as a corporation, is disregarded as an entity separate
from its owner. That means that its activities are treated the same as a sole proprietorship,
branch, or division of the owner under Regulation section 301.7701-2(a).

The rule disregarding the entity status of a wholly-owned entity does not apply to the taxes
imposed under Subtitle C (i.e., FICA, FUTA, and Federal income tax withholding,
hereinafter referred to as “employment tax”). For employment tax purposes, section
301.7701-2(c)(2)(iv) of the Regulations provides that an entity that is otherwise
disregarded as an entity separate from its owner is treated as a corporation, separate
from its single owner.

Further, in the preamble to the final regulations under section 7701 that became effective
in 2007 (see Treasury Decision 9356, 2007-39 I.R.B. 675, 72 F.R. 45891), the IRS stated:

 Section 3306(c)(8) provides that services performed for an organization
 described in section 501(c)(3) are excepted from the definition of employment
 for Federal Unemployment Tax Act (FUTA) purposes. Even though a
 disregarded entity owned by a section 501(c)(3) organization will be regarded
 for employment tax purposes, the disregarded entity will continue to be
 considered an unincorporated branch or division of the section 501(c)(3)
 organization for other Federal tax purposes. For example, the disregarded
 entity will be considered an unincorporated branch or division of the section
 501(c)(3) organization for purposes of the organization's annual information
 reporting requirements under section 6033. See Announcement 99-102 (1999-
 2 CB 545). Because section 3306(c)(8) looks to the employer's status for
 income tax purposes to establish the basis for exemption from FUTA, a
 disregarded entity owned solely by a section 501(c)(3) organization is
 considered exempt from tax under section 501(c)(3) for purposes of section
 3306(c)(8). Thus, a disregarded entity owned solely by a section 501(c)(3)
 organization will not be subject to FUTA tax on wages it pays its employees.

PLR-111059-20 5

The following six factors are considered in determining whether an organization is an
instrumentality of one or more states or political subdivisions: (1) whether the organization
is used for a governmental purpose and performs a governmental function; (2) whether
performance of its function is on behalf of one or more states or political subdivisions; (3)
whether there are any private interests involved, or whether the states or political
subdivisions involved have the powers and interests of an owner; (4) whether control and
supervision of the organization are vested in public authority or authorities; (5) whether
express or implied statutory or other authority is necessary for the creation and/or use of
such an instrumentality, and whether such authority exists; and (6) the degree of financial
autonomy and the source of its operating expenses. See Rev. Rul. 57-128, 1957-1 C.B.
311.

Analysis

We apply the factors in Rev. Rul. 57-128 to determine whether Organization 2 and
Organization 1 are wholly-owned instrumentalities of State. Under section 301.7701-
2(c)(2)(iv) of the Treasury Regulations, Organization 1 is treated as a corporation
separate from its owner for employment tax purposes. Therefore, we apply the factors in
Rev. Rul. 57-128 to each organization separately to determine whether Organization 2
and Organization 1 are wholly-owned instrumentalities of State.

Organization 2 performs a legitimate governmental purpose by supporting the educational
mission of University and College M and providing medical and other health services to
the Community. Organization 1 also performs a legitimate governmental purpose as it
was intended to operate collaboratively with Organization 2 and was formed to function
as a unitary component of Organization 2 by acting as the Faculty Practice Plan for
College M to provide health care as an integral component of the academic and research
mission of University, and to coordinate and provide for the clinical care aspect of such
activities. Organization 1 is the operational entity in providing health care services and it
employs all the health care providers and support personnel. As such, Organization 2 and
Organization 1 satisfy the first factor of Rev. Rul. 57-128 since they are both used for a
governmental purpose of educating students at College M and both perform
governmental functions of teaching medical students through clinical instruction and
research activities, as well as providing medical and other health care services.

Both Organization 2 and Organization 1 satisfy the second factor, performance of
functions on behalf of the state. Organization 2 was formed to carry out the purposes of
University and its medical school, College M. In turn, Organization 1 was formed to carry
out the purposes of College M and Organization 2. Further, Organization 2, through the
actions of Organization 1, performs an ancillary function for College M at College M-
operated hospitals by providing professional medical and related health care services.

Organization 2 represents that no private interests have any voting interests, and that
State has the interest and powers of an owner through University, a political subdivision
of State. Organization 2’s regulations specify that it is wholly-owned by University, which
PLR-111059-20 6

exercises its authority over Organization 2 through certain officers and employees of
University as specified in Organization 2’s regulations. Further, Organization 2’s Board is
composed of the following individuals: (a) Dean of College M as the chairperson of the
Board; (b) Chairperson of each clinical department of College M; (c) Nine faculty
members of College M; (d) President of Organization 2 as an ex-officio voting member;
and (e) Two additional ex-officio non-voting members: the Executive Director of
Organization 2 and the Executive Director of the College M Hospitals. Accordingly,
Organization 2 is directly controlled by University, to whom it must submit annual
accountings through the Board. Organization 2’s assets are required to be used for
charitable purposes and for the benefit of, to perform the functions of, and to carry out the
purposes of University and College M. Upon dissolution, Organization 2’s regulations
specify its assets shall be distributed to University to the extent it is considered a political
subdivision under section 115 of the Code, and if not, another section 501(c)(3)
organization or political subdivision per section 115 selected by the Board.

Similarly, Organization 1 represents that no private interests are involved. Organization
1’s regulations specify that its net earnings shall not inure to the benefit of any private
interests. Further, Organization 1 is directly controlled by its single member, Organization
2, which functions as its manager. Ultimately, Organization 1 is indirectly controlled by
University, as Organization 2 is under the control of University. As such, Organization 2
and Organization 1 satisfy the third factor insofar as both represent that no private
interests are involved and that the state has interests and powers of an owner through
University, a state university and political subdivision of State, whether directly in the case
of Organization 2 or indirectly in the case of Organization 1.

The fifth factor in Rev. Rul. 57-128 requires that express or implied statutory authority be
necessary for the creation and use of Organization 2 and Organization 1. Both
Organization 2 and Organization 1 were created to further the educational and related
health care purposes of University, a political subdivision of State and its medical school,
College M. Section A of the Statute grants University’s Board the authority to do all things
necessary for the creation, proper maintenance, and successful and continuous operation
of the University. Therefore, the fifth factor is satisfied.

The sixth and final factor in Rev. Rul. 57-128, which considers the degree of financial
autonomy and the source of its operating expenses, is also satisfied for Organization 2
and Organization 1. Organization 2’s main source of income is generated by Organization
1 through the provision of medical services to patients by Organization 1 physicians who
are also faculty members of College M. Organization 2 monitors Organization 1’s finances
through the use of an independent accounting firm. Further, University, a political
subdivision of State, monitors Organization 2’s finances through the use of the
aforementioned annual accountings submitted by the Board. Solely on the basis of the
information submitted, we rule as follows:
PLR-111059-20 7

1. Organization 2 and Organization 1 have satisfied all of the factors listed in Rev. Rul.
   57-128. Accordingly, we conclude that Organization 2 and Organization 1 are
   instrumentalities of State for purposes of Code section 3121(b)(7).

2. Therefore, for periods after July 1, 1991, wages paid to an employee of Taxpayer are
   subject to the OASDI portion of the FICA tax unless the employee is a qualified participant
   in a retirement system maintained by State. No opinion is expressed as to whether any
   employees of Organization 2 or Organization 1 are qualified participants in a retirement
   system maintained by State.

3. Wages paid to employees of Organization 2 and Organization 1 are generally subject
   to the Medicare portion of FICA tax, unless they qualify for the continuing employment
   exception under section 3121(u)(2)(C) of the Code. No opinion is expressed as to whether
   any employees of Organization 2 or Organization 1 qualify for this exception.

4. Organization 2 is an organization described in section 501(c)(3) of the Code as well as
   a wholly-owned instrumentality of State. Organization 1 is wholly-owned by Organization

5. Further, although Organization 1 is owned by Organization 2, it is indirectly controlled
   by University and satisfies all of the factors listed in Rev. Rul. 57-128. As such, we find
   that Organization 1 is also a wholly-owned instrumentality of State. Further, because
   section 3306(c)(8) looks to the employer’s status for income tax purposes to establish the
   basis for exemption from FUTA, Organization 1 is considered exempt from tax under
   501(c)(3) for purposes of the exemption under section 3306(c)(8) since it is wholly-owned
   by a section 501(c)(3) organization. Consequently, we conclude that the services of
   Organization 1 and Organization 2’s employees do not constitute “employment” for
   purposes of FUTA taxes.

No opinion is expressed as to the federal tax consequences of the transaction described
above under any other provision of the Code. The above analysis is based on the
assumption that Organization 2 and Organization 1 are not covered by a section 218
agreement. Furthermore, we do not express an opinion on whether the Organization 2
and Organization 1's retirement plan is a qualified plan or meets the requirements of
section 31.3121(b)(7)-2 of the Regulations. Finally, we do not express an opinion as to
whether the Organization 2 or Organization 1 and the University are an affiliated service
group under section 414(m) or whether the Taxpayer's plan is a governmental plan under
section 414(d).
PLR-111059-20 8

This ruling is directed only to the taxpayer(s) requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

                     Sincerely,



                     _________________________________
                     Lynne Camillo
                     Chief, Employment Tax Branch 2
                     (Employee Benefits, Exempt Organizations & Employment Tax)

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