United States: Appellate Court Rejects Joint Venture Appeal: Exempt Status Of Columbia Joint Venture Partner Revoked

Only ten days after hearing oral arguments on the appeal of Redlands Surgical Services from the Tax Court’s decision upholding the rejection by the IRS of an application for tax exempt status, the Ninth Circuit Court of Appeals, in a per curiam opinion adopting the Tax Court’s opinion, affirmed the Tax Court’s decision. The Court stated in its one paragraph:

The taxpayer has indicated that it will seek a rehearing by the Ninth Circuit or review by the Supreme Court. In view of the lack of any conflict among the Circuit Courts, a hearing of the issues by the Supreme Court is probably unlikely.

In 1999, the Tax Court had upheld the denial by the IRS of tax exempt status of Redlands Surgical Services ("RSS"), a nonprofit healthcare corporation. The Redlands case had tested the position of the IRS that tax exempt status was not available where the applicant’s sole purpose was to act as a general partner in a partnership of which the applicant had no effective control of the activities. The Court concluded that RSS was not operated exclusively for charitable purposes.

The IRS had enunciated this position in Revenue Ruling 98-15, issued in March 1998. Revenue Ruling 98-15 addressed the consequences of an exempt organization participating in a "whole hospital joint venture." In Redlands, the IRS applied the same test to an ancillary joint venture.

RSS is a corporate subsidiary of Redlands Health Systems ("RHS"). RHS is the parent of a corporation that operates a nonprofit hospital. The hospital wanted to increase its outpatient surgery capacity. RHS entered into an agreement with a for-profit entity that operates ambulatory surgical centers. The two formed a general partnership ("GP") for the purpose of acquiring an interest in an existing surgical center. RSS was formed by RHS solely for the purpose of acquiring the interest of RHS in GP. RSS has no other activities. GP acquired a 61% interest in the operating partnership. GP was the sole general partner of the operating partnership. Most of the limited partners of the operating partnership are physicians. A subsidiary of the for-profit corporation managed the center’s day-to-day operations.

The IRS argued that RSS had ceded effective control over its sole activity, the surgical center, to a for-profit partner and the for-profit management company. The ceding of control of the partnerships and the surgery center’s activities to for-profit parties, according to the Tax Court, conferred on those parties significant private benefits. Accordingly, the Tax Court found that RSS was not operating exclusively for charitable purposes, a requirement to obtain status as a tax exempt charitable organization. The Court rejected RSS’s argument that the critical issue was the conduct of the organization rather than control. The Tax Court concluded that merely the ability to block action by the for-profit partner was not sufficient to establish that the organization had effective control over the manner in which the partnership conducted activities. RSS lacked the formal control to respond to community needs. The absence of any control, coupled with a management contract to which the operating partnership was bound, evidenced an inability to require that the partnership be operated for charitable activities. The for-profit parties had no express or implied obligation to put the charitable objectives of RSS ahead of noncharitable, profit-making objectives of the for-profit entities.

The Ninth Circuit’s decision clearly adopts the Tax Court’s decision on control of the activities of the partnership and that control by a private person of a partnership precludes exempt status of an entity whose sole activity is participation in that partnership.

In Revenue Ruling 98-15, the IRS addressed whole hospital joint ventures, joint ventures where a tax exempt hospital contributes all of its assets to a joint venture with a for-profit operator. The Revenue Ruling discussed good and bad examples. The good example (the organization could retain its exempt status) required that the tax exempt organization have effective control over the operation of the hospital and the absence of a management agreement with any affiliate of the for-profit entity. The Redlands case is consistent with the rationale of Revenue Ruling 98-15, mandating control of the activities of the partnership in order for the nonprofit partner to be entitled to tax exempt status.

Beyond the exempt status situation, the Redlands case may also bear consideration with respect to unrelated trade or business income tax issues ("UBIT"). Often a tax exempt organization that has a number of exempt activities, for example, a tax exempt hospital, will enter into a joint venture with a for-profit entity to provide a particular ancillary service. Similar facts to the Redlands case may be presented by a hospital that otherwise has substantial exempt purpose revenues. Assuming that the revenues of the joint venture allocable to the hospital are not substantial in relation to the hospital’s other revenues, the mere fact that the hospital does not control the partnership would not likely endanger the exempt status of the hospital. However, based on the Redlands case, the IRS may conclude that the activities of the partnership are not related to the exempt purpose of the hospital, therefore, the income allocable to the hospital from the partnership should be treated as UBIT.

The IRS has recently revoked the tax exempt status of a hospital in Texas that had entered into joint venture with Columbia/HCA. St. David’s Health Care System Inc., a charitable hospital, owned and operated St. David’s Medical Center until April 30, 1996, when St. David’s entered into a partnership, doing business as St. David’s Healthcare System L.P. (the partnership), with Round Rock Hospital, an affiliate of HCA (formerly known as Columbia/HCA). The partnership owns and operates the parties’ Central Texas hospitals and related health care properties. St. David’s and Round Rock are the general partners. St. David’s share of the partnership income is spent on improving patient care, expanding the medical facilities, and furthering other community health needs, the complaint asserts.

In an October 2000 Technical Advice Memorandum, the IRS National Office supported the examining agents’ revocation recommendation. The conclusion follows the position set out in Revenue Ruling 98-15. After paying nearly $880,000 in corporate income tax, plus interest and penalties, St. David’s filed a refund claim, which the IRS disallowed. St. David’s filed an action in the Federal District Court in the Western District of Texas, seeking a refund because it qualified as a section 501(c)(3) organization, and that its partnership activities do not further private interests.

In its complaint, St. David’s notes that the partnership agreement obligates the partnership to operate the hospitals in accordance with the community benefit standard of Revenue Ruling 69-545. The partnership provided $67 million of uncompensated care in a recent fiscal year, including $24 million of charity care. These two factors were not present in the Redlands case.

The St. David’s case will provide another opportunity for judicial scrutiny of the IRS position set forth in Revenue Ruling 98-15. As we have noted, this has implications not only for hospitals in whole hospital joint ventures, but also for ancillary services joint ventures. We expect further activity by the IRS in this area in light of its success in Redlands as well as the number of partnerships similar to the one in which St. David’s is a partner.

© 2001 Greenberg Traurig