Partnering Nonprofit, Tax-Exempt Entities with For-Profit Entities: Ninth Circuit's Decision in Redlands

The Ninth Circuit, in a brief per curiam opinion, affirmed the Tax Court's opinion in Redlands Surgical Services, 242 F3d 904 (2001). The Tax Court held that an exempt organization's nonprofit subsidiary, which was in partnership with a for-profit corporation, ceded control over its proposed tax-exempt activity to the for-profit corporation and therefore was not operated exclusively for exempt purposes. Caution should, therefore, be exercised when structuring any similar transactions, to take into account the analysis set forth in the Tax Court's Redlands decision.

Background

Redlands Health Systems, a holding company with subsidiaries operating hospitals, is a nonprofit, tax-exempt organization under Sec. 501(c)(3). SCA Centers and its affiliates are for-profit corporations. In 1990, Redlands Health Systems formed a partnership with SCA Centers to acquire a 61% interest in another partnership operating a surgery center. Redlands Health Systems subsequently formed Redlands Surgical Services (RSS), a nonprofit corporation, and transferred its partnership interest in the surgery center to RSS. The partnership interest was RSS's sole activity. RSS applied for a tax exemption under Sec. 501(c)(3), but the Service issued an adverse determination. RSS then brought an action for a declaratory judgment in the Tax Court, requesting it to determine the correctness of the adverse determination.

Tax Court

The IRS argued that RSS was not operated exclusively for charitable purposes because it operated for the benefit of private parties and failed to benefit a broad cross-section of the community. The Service contended that the partnership agreements and related management contract were structured to give for-profit interests control over the surgery center. Further, the surgery center was a successful, profit-making business that never held itself out as a charity or operated as a charitable healthcare provider.

RSS argued that it met the operational test because its activities surrounding the surgery center furthered its purpose of promoting health for the benefit of the Redlands community, by:

• Providing access to an ambulatory surgery center for all community members based on medical need rather than ability to pay; and
• Integrating the outpatient services of Redlands Hospital and the surgery center.

RSS said its dealings with the for-profit partners were at arm's length, and that it had sufficient influence over the surgery center's activities to further its charitable goals. RSS further contended that it qualified for exemption because it was organized and operated to perform services integral to the exempt purposes of RHS (its tax-exempt parent) and Redlands Hospital (its tax-exempt affiliate).

The Tax Court held that for-profit parties effectively controlled RSS's sole activity. The operations of the surgery center were not dedicated to advancing the interests of RSS's exempt affiliates except when those interests might happen to coincide with the commercial interests of RSS's for-profit partners.

Moreover, RSS impermissibly served private interests; RSS's activity was not so substantially and closely related to the exempt purposes of its affiliates that these private interests could be disregarded. Therefore, RSS was not entitled to exemption under the integral-part doctrine.

Ninth Circuit Decision

The Ninth Circuit denied RSS's petition for review. Specifically, it adopted the Tax Court's holding that RSS "ceded effective control over the operations of the partnerships and the surgery center to private parties, conferring impermissible private benefit. [RSS] is therefore not operated exclusively for exempt purposes within the meaning of section 501(c)(3)." The Ninth Circuit also affirmed the Tax Court's conclusion that the benefit conferred on private parties by the surgery center's operations prevented RSS from attaining tax-exempt status under the integral-part doctrine.

UBIT Implications

In Redlands, RHS formed RSS as a separate nonprofit subsidiary to hold the partnership interest in the surgery center as its sole activity. The fact that the courts held that RSS ceded control over its only activity to the for-profit corporation was instrumental in the denial of its exemption. Many nonprofit hospitals entering similar joint ventures with for-profit health corporations directly own interests in surgery centers or other medical activities. In such circumstances, the IRS is attempting to impose unrelated business income tax (UBIT) on audit. However, as long as the medical activity controlled by the for-profit entity does not represent a substantial activity of the nonprofit hospital, the tax exemption of the nonprofit hospital may not be jeopardized.

IRS Initiatives

Redlands will likely cause the Service to increase the level of scrutiny applied to management contracts and to questions such as:

• How have responsibilities been delegated in a particular joint venture?
• Who has day-to-day control?
• Who decides how assets are used?

The IRS's arguments in Redlands are similar to those expressed in Rev. Rul. 98-15, the whole-hospital joint-venture ruling. The ruling stated for the first time that the Service would sanction whole-hospital joint ventures between nonprofit and for-profit entities under some circumstances. The ruling presented two contrasting fact patterns and, for each, discussed the IRS's position on the impact the joint venture would have on the tax-exempt status of one of the joint ventures.

The appellate decision in Redlands may strengthen the Service's position in cases like St. David's Health Care System, DC TX, 3/12/01. St. David's refund suit argues that the IRS erred in revoking its exemption and assessing corporate income tax following a whole-hospital joint venture with a for-profit partner.

From Randy Snowling, J.D., Washington, DC, and Thomas M. Mayer, CPA, Minneapolis, MN