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GT Alert

District Court Issues Whole Hospital Joint Venture Decision

July 2002
By Harry J. Friedman, Greenberg Traurig, Phoenix Office

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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.

Harry J. Friedman
"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 to HCA.

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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