Managed Service Organizations: An Introductory Overview to a New Potential Tax Strategy

Managed Service Organizations (MSOs) have become increasingly popular among businesses seeking to streamline operations, achieve regulatory compliance, and optimize tax outcomes. While MSOs are most commonly associated with the healthcare sector, the MSO model is also used in other industries, such as finance, technology, and professional services. This article introduces MSOs, outlines their typical structure, and provides an overview of their tax treatment and potential complications, setting the stage for a deeper exploration of MSO tax strategies in future installments.

An MSO is a separate legal entity—often a corporation, limited liability company (LLC), or partnership—established to provide a suite of management and administrative services to one or more operating businesses. In healthcare, for example, an MSO might handle billing, human resources, IT, compliance, and facilities management for physician practices, allowing clinicians to focus on patient care while the MSO manages business operations. The MSO enters into service agreements with its client businesses, charging fees for its services, which may be structured as flat fees, percentages of revenue, or cost-plus arrangements.

MSOs are typically owned by individuals, investors, or even the same parties who own the client businesses. The MSO operates independently, with its own employees, assets, and financial statements. The relationship between the MSO and the client business is contractual, not one of ownership or control, although common ownership is frequent in practice.

From a federal tax perspective, each MSO is a separate taxpayer and files its own tax return, reporting income from management fees and deducting its operating expenses. The client businesses likewise deduct the management fees as business expenses. However, several important tax rules can come into play:

• Affiliated Service Group Rules: If the MSO and the client businesses are commonly owned and the MSO’s principal business is providing management functions to those businesses, they may be treated as an “affiliated service group.” Meaning that in certain instances, such as employee benefit plans, all employees of the MSO and the client businesses are aggregated and treated as employed by a single employer. 

• Income Allocation: The IRS requires that transactions between commonly controlled entities, such as an MSO and its client businesses, be conducted at arm’s length. If management fees are not set at fair market value, the IRS may reallocate income or deductions to prevent tax avoidance and ensure that each entity’s income clearly reflects its economic activity.

MSOs offer several business and tax advantages. They allow operating businesses to focus on their core competencies while leveraging the MSO’s specialized expertise and economies of scale. From a tax perspective, MSOs can facilitate centralized expense management, potential tax planning opportunities, and improved compliance with complex benefit plan rules. However, the structure must be carefully implemented to comply with the Internal Revenue Code and to ensure that all arrangements have economic substance and a valid business purpose.

In future articles, we will explore specific tax strategies and planning opportunities for MSOs in greater detail. If you have any questions, then please reach out to our team at (202) 455-6010 or schedule a confidential consultation.