IRS Rules on Hospital Partnerships

Ruling threatens joint ventures by charities and companies

When Columbia/HCA Healthcare Corporation and the Sisters of Charity of St. Augustine Health System, an Ohio chain of Catholic hospitals, decided to join forces in 1996, both sides touted the arrangement as a model for charities that needed quick cash to survive amid intensified competition.

Today, more than 60 similar arrangements are in place, involving hundreds of millions of dollars. But many of those ventures could now face trouble from the Internal Revenue Service, which is worried that companies are getting undue financial benefits through the arrangements.

In a long-anticipated ruling that is scheduled to appear in the Internal Revenue Bulletin this week, the I.R.S. for the first time spells out the conditions that non-profit hospitals must meet if they want to ally with a business and keep their charity status.

While the ruling deals only with hypothetical cases, it clearly suggests that many joint ventures now in operation, including arrangements like the one Sisters of Charity has with Columbia, could be in jeopardy because of the amount of control that non-profit organizations have ceded to for-profit businesses. The I.R.S. decision could force many non-profit organizations to take back the hospitals and other assets they had put into joint-venture partnerships, or sell them outright to their for-profit partners.

The Sisters of Charity health system, if it wants to hold on to its tax-exempt status, will probably now need to defend its decision to join with Columbia to form a new, for-profit, taxable entity — Caritas Healthcare Partnership — to oversee the day-to-day operations of the non-profit hospitals. Columbia paid $200-million to Caritas, and Sisters of Charity turned over all of its buildings, equipment, and other assets to the partnership.

Each side got something out of the deal. Columbia, as a co-owner, got a portion of the partnership’s earnings and an ownership interest in the assets. Sisters of Charity did not have to suffer through an outright takeover and has been able to continue its existence as a non-profit organization. Under the new arrangement, Sisters of Charity can devote most of its time to making grants to local charities from its share of the earnings from the taxable entity and does not have to worry about the headaches of running the hospital.

The I.R.S. says that while both sides may get benefits, non-profit entities like Sisters of Charity must demonstrate that society receives enough benefits from the partnership’s operations and the community grants to justify the continuation of the charity partner’s tax-exempt status.

The test, according to the ruling, will be whether the non-profit organization maintains control over the assets it turns over to a taxable partnership.

“We’ll be looking beyond just the bare structure into how the transactions actually work,” explains Marc Owens, director of the I.R.S.’s Exempt Organizations Division. “Who’s calling the shots, what’s happening to the money? We will be looking, in short, for whether or not those in control of the charity are exercising their fiduciary responsibilities toward those assets.”

Many non-profit leaders and observers praise the I.R.S. for taking a hard stand against what they believe amounts to for-profit companies’ using charity tax breaks for their own gains.

“This ruling calls into question all of those joint ventures which were profit-maximizing entities masquerading as charities,” says Linda Miller, president of Volunteer Trustees for Not-for-Profit Hospitals, a national organization that represents about 150 boards. “Finally the I.R.S. is saying these deals are outrageous. This ruling basically wipes out the joint-venture structure as an option.”

Ms. Miller contends that many of the joint ventures essentially allowed for-profit chains to buy non-profit hospitals for less than their actual value. In outright sales, a company that takes over a non-profit hospital has to follow strict federal rules about what to do with the charitable assets. Proceeds from such sales are usually put into charitable foundations to compensate the public for, among other things, years of lost tax revenue.

But under the joint ventures, says Ms. Miller, companies have been getting as much control as if they were full owners — while essentially paying half the price they would owe in a takeover.

“It really should be very upsetting to people, the billions of dollars in charitable assets that have been squandered,” she says.

In its ruling, the I.R.S. uses two scenarios to explain its views: one in which it deems the charity’s involvement in a joint venture to be acceptable, and another in which the service says the partnership would lead to loss of the charity’s tax-exempt status. (Excerpts from the ruling appear on facing page.)

Several key factors differentiate the example that passes I.R.S. scrutiny from the one that doesn’t.

In the case that the I.R.S. finds acceptable, the charity appoints a majority of the partnership’s board members, and the hospitals in the partnership are run by a management company that has no affiliation with the founding charity or company. The partnership’s governing documents also explicitly state that any hospitals the joint venture operates must be run in a way that “furthers charitable purposes by promoting health for a broad cross section of its community.”

In the second example, the charity and the company each appoint half of the partnership’s board members. The hospitals in the partnership are run by a management company that is owned by the company that created the joint venture. The partnership’s chief executive and chief financial officers both previously worked for the for-profit company.

Two of the points raised as red flags by the I.R.S. could cause problems for Columbia and the Sisters of Charity.

First, Columbia and the Sisters of Charity each appoint an equal number of people to the partnership’s governing board. In its ruling, the I.R.S. says that it is more likely to allow a hospital to retain its charity status when it appoints a majority of the board members.

The for-profit partnership has also hired one of Columbia’s subsidiaries to manage the hospital, another cause for concern, according to the I.R.S.

Jeff Prescott, a spokesman for Columbia, says it will take time before the company knows how each of its partnerships with non-profit organizations might be affected by the ruling. The health-care chain, which is also contending with a federal investigation into charges of fraudulent billing practices at some of its sites, has partnerships with six or seven non-profit hospitals that involve 20 medical facilities. Mr. Prescott says the terms of those partnerships vary greatly.

Columbia is not alone as it scrambles to review its deals in light of the new ruling.

Rick Grafmeyer, national director for tax legislation at the accounting firm Ernst & Young, which has represented Columbia and many other for-profit companies and non-profit groups involved in such partnerships, says “a vast majority” of existing hospital joint ventures could be at risk as they are currently structured.

He criticizes the I.R.S. for taking more than two years to provide any guidance on such joint ventures. “Business doesn’t stop, it moves forward,” Mr. Grafmeyer says. “And so these people moved forward with these deals.”

Now, he says, many participants in joint ventures will face the difficult and potentially messy task of trying to fix or undo the deals — or take on the I.R.S. in court. “For anyone who’s been involved in a joint-venture deal, this ruling is really miserable news,” he says.

Most legal and health-care experts predict that the I.R.S.’s 19-page ruling will have a major impact on how all future hospital deals are structured.

Michael I. Sanders, a lawyer at Ginsburg, Feldman & Bress, in Washington, says the ruling may give non-profit organizations the upper hand in future negotiations with companies. “When we’re representing tax-exempt organizations, it gives us some negotiating strength,” he says. “We’re able to use the bad case as leverage with a for-profit. We can say, ‘Look, we can’t do this, we can’t do that. The I.R.S. won’t let us.’ ”

But Ms. Miller of Volunteer Trustees for Not-for-Profit Hospitals says charities could have a tough time finding new partners because companies will be unlikely to agree to a minority role.

She says the I.R.S.’s example in the ruling of an acceptable joint venture is unrealistic.

“It creates a kind of quasi-charitable, for-profit animal that does not exist, never has existed, and, in my view, never could exist,” she says. “It’s inconceivable that any investor would put money into one when they can’t control it or its profitability.”

Mr. Grafmeyer of Ernst & Young agrees that charities will have a tough time finding for-profit partners in the future.

But he says charities — and society — will suffer if hospital joint ventures come to an end. “What I think you’re going to see happen, unfortunately, is that more non-profit organizations are going to sell their assets in outright sales,” says Mr. Grafmeyer.

He says the ruling ignores the reality that many non-profit hospitals need quick cash to spruce up their facilities, upgrade computer systems, and make other changes in order to survive. “With a joint venture, at least you still have the community identity,” he says, as well as input from non-profit hospitals in making decisions.

Mr. Grafmeyer says non-profit groups are “tough negotiators” who have looked out for their communities’ welfare by insisting that companies take such steps as constructing AIDS clinics.

Technically, the I.R.S. ruling simply elaborates on the service’s view of existing law. But legal experts say the ruling marks a big departure from what many people previously interpreted as legally permissible.

Until now, most participants in such joint ventures had little explicit guidance from the I.R.S. About 30 charities had put in requests to the service — some of which date back to 1995 — for approval of specific deals. But almost all of the requests went unanswered while the I.R.S. prepared its revenue ruling.

Mr. Grafmeyer says that because the I.R.S. took so long to provide guidance, it should show leniency when examining existing deals. If the I.R.S. now thinks such deals have problems, he says, “why didn’t they answer my ruling requests three years ago?”

Given the new ruling, Mr. Grafmeyer predicts that many groups will have to undo their partnerships and take back their assets, sell their stakes in the ventures to their for-profit partners, or head to tax court to defend their deals.

Such scenarios could cause big problems for the non-profit organizations involved. If assets have risen in value while under a partnership’s control, for example, a non-profit organization may have to come up with cash to pay taxes on the gain before the partnership can be dissolved and control of the hospital reverts to the charity.

T. J. Sullivan, a lawyer at Gardner, Carton & Douglas, in Washington, and a former special assistant for health care at the I.R.S., says he believes that the service will be open to some negotiations. “I sense from the service a willingness to work with people on these transactions to resolve the issues on a case-by-case basis,” he says.

Mr. Owens says the I.R.S. is willing to meet with people who have questions or concerns. But, he adds, “organizations that entered into deals and who relied on the advice of counsel do not have a document on which they can rely. They don’t have a ruling from the service. And they need to seriously consider the possible impact of the revenue ruling on them.”

Figuring out just what the impact will be, however, can be tricky.

“The ruling gives you a black and a white case,” says Mr. Sanders, the Washington lawyer who has also written a book on joint ventures involving charities. “We don’t have enough guidance to deal with the gray cases.”

For example, Mr. Sanders says, it is unclear whether all deals in which a non-profit hospital and a for-profit company evenly split control of the partnership’s board would flunk the I.R.S.’s test.

Mr. Owens says no one point alone would cause a charity to lose its tax-exempt status. He says the I.R.S. will evaluate each case by considering a combination of “facts and circumstances.”

Groups that decide that they need to take steps to fix or undo the partnerships they had formed need to be careful to avoid reaping improper financial or other gains in the process, Mr. Owens cautions.

He says that the local offices of the I.R.S. have money in their budgets this year earmarked for examinations of charities and companies involved in joint ventures.

The I.R.S. ruling by no means puts an end to all partnerships between businesses and charities. But with the ruling, the I.R.S. makes clear that non-profit groups need to take many steps to insure that they are not compromising their charitable missions.

Unlike partnerships involving hospitals, most joint ventures do not require charitable assets to be given up to a taxable partnership that runs the non-profit facilities.

Community-development charities, for example, frequently form partnerships with companies to revitalize economically depressed areas. But the non-profit groups in most of those cases retain their assets and run their own programs. In higher education, colleges and universities often form deals with companies to do research and develop new products, but the universities run the laboratories that conduct such research.

Still, the ruling is expected to be a significant one for all types of non-profit organizations as joint ventures involving charities become increasingly common and complex. “Any non-profit that has an activity that could be exploited commercially theoretically could be in a joint venture,” says Mr. Owens of the I.R.S. “This ruling addresses some of our concerns.”

Correction

This article incorrectly described some aspects of the partnership arrangement between Sisters of Charity St. Augustine and Columbia/HCA. The arrangement involved three separate partnerships, not just one. In each, the Sisters of Charity Health System holds a 50-per-cent stake, but the partnership boards do not have equal numbers of people appointed by the Sisters of Charity and Columbia. The participants have not disclosed the amount Columbia paid to join the partnerships; the $200-million cited in the article is the amount the Sisters of Charity subsidiaries had left over from the transactions after subtracting liabilities and other expenses. The Sisters of Charity say their primary motivation in seeking the partnerships was “to insure the long-term delivery of Catholic health care” amid increasing competition, not as a short-term way to stay afloat financially.