District Court Issues Whole Hospital Joint Venture Decision
By Harry J. Friedman, Greenberg Traurig,
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A significant issue for tax-exempt hospitals in recent years has been
the position of the Internal Revenue Service (the "Service") with respect
to so-called "whole hospital joint ventures" and ancillary joint ventures
with for-profit partners. In St. Davidís v. United States, (June
7, 2002), a recent decision by a U.S. District Court in Texas, the first
challenge to a whole hospital joint venture resulted in a defeat for the
Service. While the case directly addresses whole hospital joint ventures,
the Courtís conclusions may also carry guidance for other joint ventures
between for-profit and tax-exempt organizations.
|"The Courtís conclusions may
also carry guidance for other joint ventures between for-profit
and tax-exempt organizations."
During the 1990s, for-profit hospital companies, such as Columbia/HCA
(now HCA, Inc.) and Tenet, purchased a number of tax-exempt hospitals. In
many cases, the tax-exempt hospital corporation was cashed-out and had no
further interest in the operations of the hospital. The former hospital
corporation typically became a private foundation and used the proceeds
of the sale of assets for various charitable purposes. The private foundation
retained its tax-exempt status because of its ongoing charitable activities.
However, in a number of situations, the seller retained a partnership
interest with the for-profit hospital company. The joint venture presented
the question of whether the health care activities of the joint venture
would support the continuing tax-exempt status of the former tax-exempt
hospital corporation or if the activities of the joint venture are tainted
by the for-profit partner.
While this issue rose to prominence because of the large number of proposed
whole hospital joint ventures, the same issues are presented in the case
of other types of joint ventures between for-profit and non-profit entities.
In addition, the issue does not always involve the tax-exempt status of
the tax-exempt organization. In many cases, the joint venture with a for-profit
organization that engages in what would otherwise be exempt purpose activities
for the tax-exempt organization is not the sole activity of the tax-exempt
organization. In those circumstances, what is at stake is whether the income
should be treated as exempt purpose income, exempt from income tax, or alternatively,
should constitute unrelated trade or business income subject to income tax
because of the participation by the for-profit entity. This type of situation
can be illustrated by an ambulatory surgery center joint venture between
physicians and a tax-exempt hospital.
In 1998, the Service issued guidance on the consequences of a whole hospital
joint venture in Revenue Ruling 98-15. The Revenue Ruling contains two examples.
The "good example" presents a joint venture managed by a governing board
consisting of a majority of whom were selected by the tax-exempt entity.
A majority of the exempt representatives must approve a list of major decisions.
The joint venture is required to operate the organization to further charitable
purposes; and, it is the duty of the governing board to operate the venture
in a manner that furthers charitable purposes by promoting health over financial
benefit to the members. The joint venture is managed by a management company
that is unrelated to either member of a joint venture. In the "good example,"
the tax-exempt organization retains its tax-exempt status because, in part,
of its control over the activities of the joint venture.
In the "bad example," the tax-exempt entity and the for-profit entity
each choose three members of the managing committee and the majority of
the board members must approve major decisions. The venture is managed under
a management agreement with a wholly owned subsidiary of the for-profit
partner. Notwithstanding that the profit derived by the tax-exempt organization
will be used for charitable purposes, the ability of the for-profit entity
to share control with the tax-exempt entity and the inability of the joint
venture to initiate programs without the for-profit entity agreeing support
a conclusion that the joint venture is not operated for charitable purposes
and thus, the tax-exempt hospital entity was no longer operating primarily
for charitable purposes. As in the "good example," control appears to be
the major factor supporting the Serviceís decision.
In a case decided in 1999, Redlands Surgical Service, Inc. v. Commissioner,
113 T.C. 47 (1999), the Tax Court concluded that a subsidiary of a tax-exempt
hospital, whose sole activity was acting as one of two general partners
in an ambulatory surgical center joint venture, was not entitled to tax-exempt
status. The Tax Courtís decision noted that the non-profit corporation had
ceded control to the for-profit parties and the joint venture had no obligation
to put charitable purposes before profit making objectives. As a result,
there was no assurance that the partnership would be operated in furtherance
of charitable purposes. See, GT Alert (July, 1999), IRS
Wins Joint Venture Case.
In the St. Davidís case, St. Davidís had operated an acute-care
hospital in Austin, Texas since 1925. In 1996, it entered into a limited
partnership agreement with HCA. St. Davidís contributed all of its hospital
and medical assets and HCA contributed its Austin-area hospitals and other
medical assets. The two general partners of the partnership were St. Davidís
and HCAís wholly owned subsidiary. The HCA subsidiary was the managing partner
of the partnership. St. Davidís ownership interest in the partnership, as
both a limited and general partner, was 45.9%.
The Service revoked St. Davidís tax-exempt status concluding, "it was
no longer engaged in activities that primarily further a charitable purpose."
The District Court addressed two issues presented by the Service as a basis
for revoking tax-exempt status. First was the absence of a community board.
In this case, half of the board was appointed by St. Davidís and the other
half by HCA. The Court concluded, as a matter of law, that a community board,
while a point in favor of a tax-exempt status in the case of the hospital,
is not an absolute requirement. The Court notes that in Revenue Ruling 69-545,
the seminal pronouncement on factors supporting tax-exempt status of a hospital,
a community board is only a factor and not an absolute requirement. Further,
the Court notes that the partnership agreement provided that all hospitals
owned by the partnership must be operated in accordance with the "community
benefits standard" described in Revenue Ruling 69-545. Should a hospital
fail to meet that standard, St. Davidís had a unilateral right to dissolve
the partnership. The District Court observed that the purpose of the community
board is to ensure that the communityís interests are given precedence over
any private interests. Voting strength alone is not the issue, according
to the District Court. The protection provided the St. Davidís representatives
were sufficient to conclude that there is a community board.
The District Court also addressed the Serviceís argument that the joint
venture provided a private benefit to HCA. The partnership agreement, according
to the District Court, clearly indicated that the charitable purposes of
the partnershipís activities as well as the voting rules and rights of the
non-profit partner prevented "any usurpation of that purpose by HCA." The
Court concluded that St. Davidís power to ensure that the manager and CEO
of the hospital were to its liking was sufficient to prevent private benefit
Clearly, the District Court has rejected the relatively simplistic analysis
of Revenue Ruling 98-15 in determining whether or not a joint venture is
operated for charitable purposes. If the St. Davidís decision is
affirmed on appeal (we believe an appeal likely), the Service will have
to consider refining the standards in Revenue Ruling 98-15. Future rulings
from the Service may include the protections that must be given to the tax-exempt
partner to enable it to ensure the venture will be operated for charitable
purposes, and, therefore, to permit it to retain tax-exempt status.
In the case of joint ventures between tax-exempt entities and for-profit
entities where the joint venture is a secondary activity, maintaining charitable
purpose requirements similar to the agreement in St. Davidís should
protect the exempt purpose income status of the tax-exempt partnersí share
of the ventures earnings.
We recommend that tax-exempt organizations with existing joint ventures
with for-profit entities should examine the existing documents of the joint
venture in light of the St. Davidís case. Amending these documents
to strengthen the protections of the tax-exempt entity and the charitable
purpose of the partnershipís activity may benefit the tax-exempt organization
in the event of a future audit.
© 2002 Greenberg Traurig
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