The IRS Warning to Tax-Exempt Hospitals on Alliances

THE COMPETITIVE PRESSURES on nonprofit hospitals brought about by drastic changes in the economics of health care have forced these institutions to think and act more like businesses. Among the many innovations that would have been almost unthinkable in years past are the many types of joint ventures that nonprofits have entered into with for-profit entities. These have been a source of much-needed capital for the nonprofits, as well as a way of sharing the risks and benefits of providing new facilities and extending the range of medical services.

Preserving the tax-exempt status of the nonprofit hospital while structuring a workable joint venture has always been a major concern in these transactions. Just as the joint venture momentum has been picking up, the Internal Revenue Service has issued a long-awaited Revenue Ruling*1 that may derail some contemplated deals, force a radical restructuring of others and send many more back to the drawing board.

Background

In recent years, large for-profit health-care providers like Columbia/HCA and Tenet have approached or been approached by nonprofit hospitals both large and small to discuss possible relationships ranging from management contracts to outright sale. In some situations, a hospital board may want to sell or transfer its hospital to a new joint venture company formed by the not-for-profit and a for-profit, thereby enabling the hospital to obtain an infusion of capital while also allowing the hospital's board to retain a degree of control over how the hospital will operate in the future.

It is this degree of control that is at the heart of the IRS's new ruling, which was released on March 4 and became effective March 23. Apparently prompted by VHA and other alliances of nonprofit hospitals concerned over the intrusion of investor-owned companies in acquiring hospitals,*2 the new Revenue Ruling requires that, for a nonprofit hospital corporation to retain its tax-exempt status under Sec.501(c)(3) of the Internal Revenue Code, (IRC) after entering into the joint venture, the nonprofit participant must retain, under all the facts and circumstances, more than 50 percent control over the joint venture, and must "give charitable purposes priority over maximizing profits."

Examples

The Revenue Ruling cites two hypothetical cases that result in opposite conclusions. In the first, A is a nonprofit tax-exempt hospital, and B is a for-profit corporation that owns and operates a number of hospitals. B wants to invest in A, which needs additional funding, so they form C, a new limited liability company, to which A contributes all of its operating assets including its hospital, while B also contributes assets. In return, A and B receive ownership interests in C proportional to their respective contributions. C's governing board consists of three individuals chosen by A and two by B. A's appointees are community leaders not on the hospital's staff and not otherwise engaged in business transactions with the hospital. C's governing documents may only be amended with the approval of both owners, and a majority of at least three board members must approve major decisions relating to C's operations, including:

  • C's annual capital and operating budget
  • distribution of C's earnings
  • selection of key executives
  • acquisition or disposition of health-care facilities
  • contracts in excess of a certain dollar amount
  • changes to the types of services offered by the hospital
  • renewal or termination of management contracts

C's governing documents also require:

  • that the hospital be operated "in a manner that furthers charitable purposes by promoting health for a broad cross section of its community";
  • that the members of C's governing body have a duty to operate C in a manner that furthers charitable purposes by promoting health in a broad cross-section of the community and that this duty overrides any duty to operate C for the financial benefit of its owners;
  • and that all returns of capital and distributions of earnings made to C's owners be proportional to their ownership interests.

The terms of C's governing documents must be legal, binding and enforceable under applicable state laws. C will be treated as a partnership for federal income tax purposes, and A intends to use any distributions it receives from C to fund grants to support activities that promote the health of A's community and to help the indigent obtain health care. Lastly, none of the officers, directors, or key employees of A who were involved in making the decision to form C were promised employment or any other inducement by C or B and their related entities.

The Revenue Ruling analyzes the language of IRC Sec.501(c)(3) and a number of cases interpreting the statute, and concludes that A can retain its Sec.501(c)(3) status under the facts as stated. The IRS cites several reasons for its conclusion:

  • A's activities will consist of the health-care services it now provides through C as well as making grants using income derived from C to support education and research and to help provide health care to the indigent;
  • A's interest in and income from C will be proportional to the value of the assets it invested in C;
  • C's charitable purposes will have priority over maximizing profits for its owners; and
  • A's voting control of C's board and on major decisions will ensure that the assets it owns and the activities it conducts through C are used primarily to further exempt purposes.

These factors led the IRS to conclude that the nonprofit hospital continued to operate exclusively for a charitable purpose and only incidentally for the nonprofit's private interests.

Management

The Revenue Ruling further hypothesizes that C enters into a management contract with a company that is unrelated to A or B to provide day-to-day management of the hospital. The management agreement is for a five-year period, renewable for additional five-year periods by mutual consent; the management company is paid a fee based on C's gross revenue; the contract terms and conditions, including the fee structure and term, are reasonable and comparable to what other companies receive for similar services at similarly situated hospitals; and C may terminate the agreement for cause. Since the terms and conditions of the management contract are reasonable, including the terms for renewal and termination, it will not affect A's Sec.501(c)(3) tax-exempt status.

The second hypothetical offered in the Revenue Ruling posits D as a Sec.501(c)(3) tax-exempt nonprofit corporation that owns and operates an acute-care hospital. E is a for-profit corporation that owns and operates a number of hospitals and provides management services to hospitals that it does not own. D and E form a limited liability company, F, to which D contributes all its operating assets including its hospital and to which E also contributes assets.

In return, D and E receive ownership interests proportional and equal in value to their respective contributions. F's governing board consists of three individuals chosen by D and three by E. D will appoint three community leaders experienced in hospital matters but not on the hospital staff and not otherwise engaged in business transactions with the hospital. F's governing documents may only be amended with the approval of both owners, and a majority of board members must approve certain major decisions including:

  • F's annual capital and operating budgets
  • distributions of F's earnings over a required minimum
  • unusually large contracts
  • selection of key executives

F's purpose is to construct, develop, own, manage and operate the health-care facilities it owns and to engage in other activities related to health care. F is treated as a partnership for federal income tax purposes, and all capital returns and earnings distributions are made to F's owners proportional to their ownership interest.

F then enters into a management contract with a wholly owned subsidiary of E to manage F. The contract is for five years, renewable for five-year periods at the discretion of E's subsidiary. F may terminate the agreement only for cause. E's subsidiary will be paid a management fee based on F's gross revenue. The remaining terms of the contract including the fee structure are reasonable and comparable to what other companies receive for similar services at similarly situated hospitals.

D also agrees to approve the selection of two individuals to serve as F's chief executive officer and chief financial officer, both of whom previously worked for E in hospital management and have business expertise, and both of whom will work with E's subsidiary to oversee F's day to day management. Both will be compensated at rates comparable to executives at similarly situated hospitals.

D intends to use any distributions it receives from F to fund grants to support activities that promote the health of D's community and to help the indigent obtain health care. Substantially all of D's grants will be funded by its earnings from F. In addition, D's projected grant making and its participation as an owner of F will constitute D's only activities.

Exempt Purposes

Unlike the situation involving A, the IRS concludes that D will be in violation of Sec.501(c)(3) requirements when it forms F and contributes all its operating assets to F because D has failed to establish that it will be operated exclusively for exempt purposes. The IRS reasons that, even though D will still be engaged in providing health-care services through F and conducting grant-making activities with income generated through F, D (unlike A) will not be engaging primarily in activities that further an exempt purpose.

The IRS cites the absence of a binding obligation in F's governing documents for F to serve charitable purposes or otherwise provide its services to the community as a whole as evidence that F will be able to deny care to segments of the community such as the indigent.

In addition, since D and E share control of F, the IRS concludes that D will not be able to initiate programs within F to serve new health-care needs within the community without the agreement of at least one of the E-appointed governing board members. The IRS further reasons that, as a business, F will not necessarily give priority to the community's health-care needs rather than to profits.

Other negatives cited by the IRS in this scenario are:

  • that the primary source of information to the D-appointed board members will be the E-subsidiary management company and F's officers who were formerly associated with E.
  • that the E-subsidiary management company will have broad discretion over F's activities and assets and may also unilaterally renew the management agreement.

The IRS concludes, therefore, that any benefit to a for-profit participant in such a joint venture must be merely ``incidental'' to the furtherance of an exempt purpose, and if it cannot be established that the joint venture will be operated exclusively for exempt purposes, the Sec.501(c)(3) status of the nonprofit participant will be placed in jeopardy.

The Revenue Ruling comes as no surprise given the IRS's frequently expressed concern over whether tax-exempt health-care providers are or are not fulfilling their tax-exempt purposes. The clear purpose behind this "warning shot" is to remind tax-exempt providers that their status is a privilege conferred largely on the basis of the benefit they provide to their communities and that it must not be used as a vehicle for sheltering profit-making activities, no matter how well-intended.

Revenue Ruling 98-15 was issued in final, not proposed, form and without any comment period. Furthermore, it appears that the ruling will apply retroactively, so that existing joint ventures that do not meet the strict criteria set forth in the Revenue Ruling will have to be restructured if the tax-exempt status of one or more of the joint venture participants is to be protected.

This important ruling will undoubtedly have at least a temporary chilling effect on new joint ventures. Existing or contemplated joint ventures between tax-exempt health-care providers and for-profit entities will have to hew closely to the IRS's standards, which may cause many to be abandoned, particularly since for-profit participants generally want at least a 50 percent ownership interest and control. It is also important to note that this ruling may affect joint ventures between tax-exempt hospitals and physicians as well. In many of those ventures, the physicians seek at least 50 percent control, and unless properly structured, such ventures may affect a hospital's Sec.501(c)(3) status.

While the IRS's Revenue Ruling clarifies some aspects, there are many variations among these joint ventures, and the IRS will probably find itself receiving requests for private revenue rulings or other guidance in situations that do not fit the facts of the two hypotheticals presented. Given the potential menace that lies in the subtleties of these transactions, tax-exempt hospitals contemplating or already involved in joint ventures with for-profits should take appropriate steps to assure that they do not run afoul of the guidelines set forth in this Revenue Ruling and previous rulings addressing other proposed ventures.

Francis J. Serbaroli is a partner at Cadwalader, Wickersham & Taft.

  1. Ruling 98-15, published March 23, 1998.
  2. "IRS Rule Might Slow Joint Ventures," Modern Healthcare, March 9, 1998. See, also, letter dated Dec. 10, 1996 from VHA to Marcus Owens, Director, IRS Exempt Organizations Division, published in Highlights & Documents, Feb. 5, 1997.

This article is reprinted with permission from the March 30th issue of the New York Law Journal © 1998 NLP IP Company.