Healthcare Nonprofits Effective Control over Partnership Will Determine Exempt Status

In St. Davids Health Care System, Inc., 5th Cir., 11/7/03, the Fifth Circuit held that healthcare nonprofit organizations must retain effective control over their partnerships with for-profit entities to retain their tax-exempt status. The court vacated a summary judgment holding that St. Davids Health Care System Inc., an organization that operated hospitals in central Texas through a joint venture with a for-profit healthcare company, was entitled to exempt status under Sec. 501(c)(3). The Fifth Circuit stated that, to determine whether the organization is operated exclusively for a charitable purpose, the trial court must ascertain who formally and/or effectively controls the partnership.

The case will now go back to a Texas district court to determine whether St. Davids ceded control to its for-profit partner. When the trial court again hears this case, St. Davids will have $40 million in back taxesas well as millions more in future taxesat stake. Moreover, other entities considering or involved in hospital joint ventures should closely watch the outcome to determine whether partnership contracts are structured so as to survive IRS scrutiny.

Background

In 1996, due to financial difficulties, St. Davids, an exempt organization that owned and operated healthcare facilities in Texas, entered into a hospital joint venture with a subsidiary of Columbia/HCA Healthcare Corp. (HCA), a taxable, for-profit healthcare company. St. Davids contributed all of its facilities to the partnership; HCA contributed its Austin, TX facilities. St. Davids received 45.9% general and limited partnership interests.

The partnership agreement required that all hospitals owned by the joint venture operate under Rev. Rul. 69-545s community benefit standard. St. Davids retained the unilateral right to dissolve the partnership with HCA if the hospitals operations failed to meet that standard. The partnership agreement established a board of governors to oversee the joint ventures operations. The board votes in two equal blocks, one composed of members appointed by St. Davids. St. Davids reserved the right to appoint the boards chairman and to unilaterally remove the joint ventures day-to-day manager (an HCA subsidiary) and the managers chief executive officer (CEO).

In 2000, on completion of its examination of 1996 Form 990, Return of Organization Exempt from Tax, the IRS proposed to revoke St. Davids exempt status retroactive to 1996. According to the Service, after St. Davids entered into the HCA joint venture, it was no longer engaged in activities that principally furthered any charitable purpose. (Alternatively, the IRS argued that if St. Davids still qualified as exempt, its income realized through participation in the joint venture was unrelated business taxable income.) St. Davids paid the resulting deficiency and filed suit for a refund.

District Courts Decision

The district court granted St. Davids summary judgment motion that it qualified as tax-exempt under Sec. 501(c)(3), even though it had entered into a joint venture with a for-profit partner; St. Davids Health Care System, Inc., WD TX, 6/7/02. The court concluded that even after entering into the partnership, St. Davids operated hospitals for charitable purposes.

The district court held that despite St. Davids ownership of less than 50% of the joint venture and its appointment of only half of the partnerships board members, the partnership agreement provided it with substantially more control over the joint venture than HCA. The decision was the first on this issue rendered since Rev. Rul. 98-15, which addressed the continuity of a nonprofit entitys exempt status when it enters into a joint venture with a for-profit hospital organization. That ruling, which the district court did not cite, analyzes a joint-venture transaction similar to the one undertaken by St. Davids and HCA; the IRS indicated that the exempt partys lack of control over the governing board was a significant factor in determining that the nonprofit entity should not retain exempt status.

In contrast, the district court held that majority control on the basis of voting power was not the only way to satisfy the need for control over a joint ventures governing board. St. Davids control, the court said, came from its powers to (1) dissolve the partnership if the operating hospitals failed to meet the community benefit standard, (2) appoint the governing boards CEO and (3) remove the joint ventures day-to-day manager and CEO. Accordingly, the court found that St. Davids met the community benefit standard and that the joint ventures structure did not result in operations unduly benefiting HCAs private interests. (The court subsequently granted St. Davids request to recover its litigation costs of $951,570 in St. Davids Health Care System, Inc., WD TX, 9/20/02, a decision the Fifth Circuit vacated.)

Had the district courts position been sustained on appeal (as discussed below), Rev. Rul. 98-15s holdings could have been in serious jeopardy; exempt hospitals seeking to enter joint ventures with for-profit organizations could have been granted additional flexibility in structuring proposed transactions.

Arguments

The IRS appealed the district courts decision in favor of St. Davids; the Services appellate brief argued St. Davids lacked sufficient control over the joint venture. Because HCA employees ran St. Davids day-to-day operations, the Service contended that HCA effectively controlled the partnership.

St. Davids argued that it controlled the partnership by virtue of its voting power on the board of governors, which is required to act in accordance with the community benefit standard. St. Davids further argued that it fulfilled Sec. 501(c)(3)s community benefit requirements and could only do so by being involved in a joint venture with a for-profit entity, because profits are needed to fund its charitable mission.

Fifth Circuits Opinion

The appellate court set aside the district courts summary judgment decision and ordered a new trial. Citing the need to resolve issues of fact, the court held that the trial court has to ascertain which party controls the partnership to determine whether St. Davids is operated exclusively for a charitable purpose.

The IRS conceded that St. Davids was organized for a charitable purposeone of the statutory requirementsbut argued that it failed to satisfy one of the four elements of the operational test. As set forth in Nationalist Movement, 37 F3d 216, 219 (5th Cir. 1994), the operational test required St. Davids to show (1) it engages primarily in activities that accomplish its exempt purpose; (2) its net earnings do not inure to private benefit; (3) it does not spend a substantial part of its resources attempting to influence legislation; and (4) it serves a valid purpose and confers a public benefit.

Exempt Status Depends on Control

Although the Fifth Circuit ac-knowledged the powers the partnership agreement conferred on St. Davids, it questioned whether those powers were sufficient to ensure operation exclusively for a charitable purpose. The court stated that because St. Davids contributed all of its medical facilities to the partnership, it had to look to the partnerships activities to determine whether it satisfied the operational test. If St. Davids ceded control to its for-profit partner, the court held, it would lose its exempt status. Although the trial court had concluded that the partnership structure gave St. Davids control over operations (even if it did not control a majority of the partnerships board members), the Fifth Circuit found the lack of majority control troubling. It noted that although St. Davids can veto board actions that might undermine its charitable goals, it cannot necessarily ensure that the partnership will take new action that furthers its charitable purposes.

The court also questioned whether St. Davids had effective powers over the partnerships manager, an HCA subsidiary. Because St. Davids primary means of enforcement is through legal action, the court doubted that it would seek to enforce the partnership agreement every time the manager made a decision that appeared to conflict with the community benefit standard. As to St. Davids unilateral right to cancel the management contract and remove the CEO, the court noted that the IRSs evidence questioned whether St. Davids was willing to take those actions without HCAs consent. All these factors, the court concluded, demonstrated that there were genuine issues of material fact to be resolved, rendering summary judgment inappropriate.

Finally, the court observed that, in general, a partnership between a nonprofit organization and a for-profit entity raises concerns for the nonprofits exempt status, because the parties relative bargaining powers may not favor the nonprofit. This is of particular concern if the nonprofit entered into the partnership because of financial distress, as was the case here.

Conclusion

St. Davids litigation will likely go a long way toward establishing how partnership agreements between a nonprofit and for-profit entity entering into a whole hospital joint venture have to be structured. (The term whole hospital joint venture is largely self-defining; such ventures contrast with ancillary joint ventures, which are entered into to provide specific services, such as cardiac and respiratory care, magnetic resonance imaging and speech therapy.) Courts will have to decide how the control requirement can be satisfied and whether nonprofit organizations have to retain a voting majority on a joint ventures board of governors to maintain exempt status. Entities contemplating a whole-hospital joint venture should analyze future St. Davids rulings to determine the flexibility the IRS may allow in structuring partnership agreements. Organizations already involved in whole-hospital joint ventures should closely monitor the St. Davids case to assess whether partnership arrangements will survive IRS scrutiny. Millions of dollars in back taxes and litigation expenses could be at stake.

Although St. Davids addressed a whole-hospital joint venture, it also raises a question as to ancillary joint ventures between for-profit and nonprofit entities. An ancillary joint venture is not typically considered a substantial activity compared to a nonprofit entitys overall activities, and might not jeopardize the nonprofits exempt status. However, the IRS could logically argue that, in cases in which a for-profit partner controls the joint venture (through the partnership agreement or other arrangement placing operational and policy control in the for-profit partners hands), any income allocable to a nonprofit partner should be treated as unrelated business income.

Thus, the definition of control that ultimately develops through the St. Davids case may be important to consider when structuring an ancillary joint venture; organizations contemplating such ventures should also monitor deliberations to assess potential implications on proposed transactions. Finally, the ultimate result in this case may have implications for joint ventures between nonprofit and for-profit entities beyond the medical community.

From Elizabeth Magin, J.D., LL.M., and Matthew M. Berger, Washington, DC