IRS Issues Ruling Setting Standards for Hospital Joint Ventures

On March 4, 1998, the Internal Revenue Service issued Revenue Ruling 98-15 outlining the standards it will use in determining if "whole hospital joint ventures" with for-profit organizations will cause charitable hospitals to lose their tax-exempt status. The ruling requires that exempt participants have such a high level of control over such ventures and their earnings that existing partnerships involving for-profit hospital chains, such as Columbia/HCA Healthcare Corporation, are unlikely to be in compliance. While whole hospital joint ventures are still rather rare, the IRS may also apply some of the tests in Revenue Ruling 98-15 to more common types of partnership arrangements between exempt organizations and taxable entities.

Whole hospital joint ventures are unusual in that once the joint venture is in place, the exempt participant may not be furnishing any health care or other charitable services except through the venture entity. Typically, a tax-exempt hospital sells or contributes all of its facilities to a partnership or limited liability company (which is taxed as a partnership). The for-profit participant provides cash or other assets which may be used to discharge outstanding bond financings. Ownership interests in the partnerships are proportional to the net amounts contributed by the participants. The objective of the exempt participant is (i) that it retain its tax exempt status under Section 501(c)(3) of the Internal Revenue Code; (ii) that its share of the partnership earnings not be taxed as unrelated business income; and (iii) that it continue to be classified as a "hospital," not as a private foundation.

  • Revenue Ruling 98-15 describes two fact situations, one in which the exempt participant retains its exempt status and achieves its other tax objectives and one in which it does not. Under the factual situation the IRS approved:
  • The joint venture limited liability company ("LLC") was governed by a five member board, three of whom were community leaders appointed by the exempt member.
  • The LLC documents required that the hospital operated by the LLC provide emergency care without regard to ability to pay and that it meet all the other requirements applicable to tax exempt hospitals.
  • The LLC documents provided that "in the event of a conflict between operation in accordance with the community benefit standard and any duty to maximize profits, the members of the governing board are to satisfy the community benefit standard without regard to the consequences for maximizing profitability."
  • The LLC documents required a favorable vote by two of the three board members appointed by the exempt organization for (i) approval of budgets; (ii) earnings distributions; (iii) selection of key executives; (iv) acquisition and disposition of facilities; (v) changes in services; and (vi) authorization of management agreements and other major contracts.
  • There was a management agreement, but it was with an organization unrelated to either participant in the LLC.

In the situation the IRS did not approve, (i) the participants had equal representation on the governing board; (ii) there was no express requirement to provide charity care or to operate for the benefit of the community; (iii) the board members appointed by the exempt member did not have special approval rights over contracts, changes in services, etc.; and (iv) there was a management agreement with an affiliate of the for-profit participant. The immediate question raised by the Revenue Ruling 98-15 is whether any for-profit hospital chain would be willing to invest in a hospital joint venture on the terms approved by the IRS.

Hospitals and other exempt organizations enter into partnerships and other joint ventures with taxable entities for many reasons. Often a joint venture provides specialized services or operates programs that complement the principal charitable activities of the exempt participant. Tax exempt institutions, such as colleges and foundations, also purchase interests in limited liability companies and partnerships for their investment portfolios. They may also receive such interests as contributions.

The IRS is not likely to require that every joint venture in which an exempt entity holds an interest must meet all the requirements of Revenue Ruling 98-15. Compliance with some of the tests is necessary, however. Language in Revenue Ruling 98-15 suggests:

  • That if an exempt organization wishes to claim that income it receives from a partnership providing services or operating programs is not taxable, the partnership may have to meet applicable "community benefit" standards, even if that is costly to the taxable partners.
  • That unrelated business income earned by a partnership which is taxable to an exempt partner will be taken into consideration in determining whether the "principal purpose" of the exempt partner continues to be charitable and whether it continues to be tax exempt.

Even before the issuance of Revenue Ruling 98-15, exempt organizations participating in joint ventures with for-profit entities were subject to prohibitions on "inurement" and "private benefit requiring that the financial rewards they receive from the venture be commensurate with their contributions. The new ruling suggest that the IRS will continue its efforts to enforce those requirements.