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By Julius Green, CPA, JD
Joint ventures between tax-exempt hospitals and physician groups have become more commonplace in the health care industry. Most common among the joint ventures are ambulatory (referred to by the IRS as “ancillary”) joint ventures to create health care units such as endoscopy, magnetic resonance imaging and surgical centers to respond to the growing need for specialized outpatient services. In recent years, the IRS position regarding the tax implications to tax-exempt hospitals created uncertainty and slowed the number of joint ventures with physician groups. That is, until the IRS released Revenue Ruling 2004-51, which is widely viewed as providing more flexibility in structuring joint venture arrangements of this type.
Negative Tax Implications to Both Physicians and Hospital
The implication to the physicians was that they were deemed to be “insiders” with substantial influence over the affairs of the nonprofit (such as a key staff member, medical director or a physician or physician group responsible for substantial admissions to the hospital). An imbalance in the valuation of the venture could result in private inurement of the hospital’s assets to the benefit of the physicians. The physician insiders may become subject to penalty taxes based upon the excess benefit that they were deemed to have received. Where intermediate sanctions penalties are imposed, they would result in a penalty tax to the physicians equal to 25 percent of the excess benefit and the physicians would be required to return the excess benefit to the hospital. If an insider failed to return the excess benefit, the IRS could impose a 200 percent excise tax of the excess benefit!
Recent History
For some time both the courts and the IRS have struggled with the proper test to apply in determining the amount and manner of control that an exempt organization must maintain over the venture. Prior to Revenue Ruling 2004-51, the IRS had consistently maintained that if a tax-exempt hospital entered into a joint venture with a for-profit physician group and failed to exercise control over the venture, the revenue from the activity will be unrelated taxable income and, more importantly, the exempt organization’s exempt status can be revoked. The IRS continued to take the position that a 50 percent or less ownership interest does not assure the charity of control; it merely permits the charity to exercise a veto power. As a result, the IRS concluded that the charity might not be able to act in a manner consistent with its charitable purpose.
Until Revenue Ruling 2004-51, the available guidance consisted of the Redlands Surgical Services case, Revenue Ruling 98-15 and the St. David’s Health Care System case, all involving whole hospital joint ventures. Each of these rulings was unfavorable – they concluded that any venture that was structured in a manner that allowed the physician profit interest to impinge upon the charitable focus of the hospital. The guidance resulted in adverse tax consequences to both parties and posed a challenge to hospitals and physicians interested in combining their resources.
St. David’s Case
St. David’s was exempt as an organization and operated an acute-care hospital in Austin, Texas. In 1996, St. David’s entered into a limited partnership with HCA, Inc., a for-profit health care company. St. David’s contributed all of its hospital and medical assets and became both a general and limited partner with nearly a 46 percent ownership interest in the partnership. HCA contributed its Austin area hospitals and medical assets, and the company and its related entities had a 54 percent ownership interest.
In October 2000, the IRS revoked St. David’s tax-exempt status retroactive to the partnership’s formation in 1996 and assessed taxes against St. David’s. The IRS argued that, because of its partnership with HCA, St. David’s forfeited its exemption because it relinquished control over its operations to HCA. The IRS asserted that, when a non-profit loses control, it could no longer ensure that its activities in connection with the partnership primarily further its charitable purpose. St. David’s won a decision in the district court that ordered the Government to refund the taxes paid by St. David’s for the 1996 tax year as well as $951,569.83 in attorney’s fees and litigation costs. Upon appeal by the Government, the United States Court of Appeals-Fifth Circuit vacated the district court’s decision and remanded the case for further proceedings. The most recent ruling in the Fifth Circuit Court of Appeals favoring St. David’s is the result of the remand.
In March 2004, after several court battles, a jury in the Fifth Circuit Court of Appeals ruled that St. David’s Hospital had sufficient control over its joint venture with a for-profit partner to ensure that the venture was operating in a charitable manner. As a result, the IRS lost this battle in establishing a high water mark for the definition of control in joint ventures between exempt and for-profit organizations.
The St. David’s ruling established that control could be established even in a 50/50 joint venture but was in the context of a whole hospital joint venture. The result of St. David’s, though favorable, continued to leave unanswered the question of control in more common ancillary joint ventures that had become more common between physicians and tax-exempt hospitals.
Revenue Ruling 2004-51
On the heels of the St. David’s decision, the IRS responded with Revenue Ruling 2004-51. In the Ruling, the IRS held that an exempt organization that enters into an ancillary joint venture over which it does not have control would not affect its exempt status nor result in unrelated business income to the hospital.
The Ruling focused upon a tax-exempt, Section 501(c)(3) university which provided technical training seminars to elementary and secondary schoolteachers on the university’s campus. The university sought to expand its training programs by providing interactive video training to students at off-campus locations by forming a joint venture limited liability company (LLC) with a for-profit video company. Both the university and the video company held a 50 percent interest in the capital and profits of the LLC consistent with their respective contributions made to the venture. Similarly, the LLC agreement provided that each party would appoint three board members with equal voting power.
The LLC is responsible for conducting the operations of the seminars, including advertising, enrolling students, arranging for the facilities and broadcasting the seminars to the off-campus participants. The courses would contain the same educational training content as provided by the university’s campus programs by using university faculty. The only difference would be that the students/teachers would participate through an interactive link at the off-campus site. The governing documents give the university exclusive rights to approve the curriculum, training materials and instructors, and to determine standards for successful completion of the seminars. The video company is given responsibility for selection of the off-campus sites and to approve the technical components of the program. The parties share responsibility for all other aspects of the program equally. Importantly, the LLC agreement requires that all contracts and transactions entered into by the LLC be at arm’s length and at fair market value and forbids the LLC from acting in a manner that would jeopardize the tax-exempt status of the university.
The IRS concluded that the joint venture would not jeopardize the exempt status of the university, nor would the profits from the LLC result in unrelated business income taxes.
While the implications of the ruling should not be overstated – there is clearly a preference that the tax-exempt organization ensures that its assets are used in a manner that furthers its exempt status – the ruling does signal a change in the IRS position that control is the overriding factor in ancillary joint ventures with for-profit partners. In many respects, the ruling provides more comfort than ever that tax-exempts and their for-profit partners can enter into mutually beneficial partnership arrangements.
Though the fact pattern in Revenue Ruling 2004-51 involved a joint venture between a university and a for-profit company, most agree that the result establishes a favorable result for physician groups and tax-exempt hospitals to enter into ancillary joint ventures without the concerns and negative implications of the earlier whole hospital guidance that preceded it.
Julius Green, CPA, JD, is a tax partner in the Philadelphia office of Parente Randolph, LLC and is Director of the Firm’s Tax Exempt Organization Practice.
