Healthcare nonprofit's effective control over partnership will determine exempt status.

In St. David's 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. David's 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. David's ceded control to its for-profit partner. When the trial court again hears this case, St. David's will have $40 million in back taxes--as well as millions more in future taxes--at 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 IR.S scrutiny.

Background

In 1996, due to financial difficulties, St. David's, 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. David's contributed all of its facilities to the partnership; HCA contributed its Austin, TX facilities. St. David's received 45.9% general and limited partnership interests.

The partnership agreement required that all hospitals owned by the joint venture operate under Rev. Rul. 69-545's "community benefit standard." St. David's 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 venture's operations. The board votes in two equal blocks, one composed of members appointed by St. David's. St. David's reserved the right to appoint the board's chairman and to unilaterally remove the joint venture's day-to-day manager (an HCA subsidiary) and the manager's 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. David's exempt status retroactive to 1996. According to the Service, after St. David's 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. David's still qualified as exempt, its income realized through participation in the joint venture was unrelated business taxable income.) St. David's paid the resulting deficiency and filed suit for a refund.

District Court's Decision

The district court granted St. David's 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. David's Health Care System, Inc., WD TX, 6/7/02. The court concluded that even after entering into the partnership, St. David's operated hospitals for charitable purposes.

The district court held that despite St. David's ownership of less than 50% of the joint venture and its appointment of only half of the partnership's 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 entity's 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. David's and HCA; the IRS indicated that the exempt party's 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 venture's governing board. St. David's 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 board's CEO and (3) remove the joint venture's day-to-day manager and CEO. Accordingly, the court found that St. David's met the community benefit standard and that the joint venture's structure did not result in operations unduly benefiting HCA's private interests. (The court subsequently granted St. David's request to recover its litigation costs of $951,570 in St. David's Health Care System, Inc., WD TX, 9/20/02, a decision the Fifth Circuit vacated.)

Had the district court's position been sustained on appeal (as discussed below), Rev. Rul. 98-15's 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 court's decision in favor of St. David's; the Service's appellate brief argued St. David's lacked sufficient control over the joint venture. Because HCA employees ran St. David's day-to-day operations, the Service contended that HCA effectively controlled the partnership.

St. David's 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. David's 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 fired its charitable mission.

Fifth Circuit's Opinion

The appellate court set aside the district court's 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. David's is operated exclusively for a charitable purpose.

The IRS conceded that St. David's was organized for a charitable purpose--one of the statutory requirements--but 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. David's 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 acknowledged the powers the partnership agreement conferred on St. David's, it questioned whether those powers were sufficient to ensure operation exclusively for a charitable purpose. The court stated that because St. David's contributed all of its medical facilities to the partnership, it had to look to the partnership's activities to determine whether it satisfied the operational test. If St. David's ceded control to its for-profit partner, the court held, it would lose its exempt stares. Although the trial court had concluded that the partnership "structure" gave St. David's control over operations (even if it did not control a majority of the partnership's board members), the Fifth Circuit found the lack of" majority control troubling. It noted that although St. David's 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. David's had effective powers over the partnership's manager, an HCA subsidiary. Because St. David's 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. David's unilateral right to cancel the management contract and remove the CEO, the court noted that the IRS's evidence questioned whether St. David's was willing to take those actions without HCA's consent. All these factors, the court concluded, demonstrated that there were genuine issues of material fact to be resolved, rendering summary judgment inappropriate.

Finally, die court observed that, in general, a partnership between a nonprofit organization and a for-profit entity raises concerns for the nonprofit's 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. David's 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 venture's board of governors to maintain exempt status. Entities contemplating a whole-hospital joint venture should analyze future St. David's rulings to determine the flexibility the 1RS may allow in structuring partnership agreements. Organizations already involved in whole-hospital joint ventures should closely monitor the St. David's 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. David's 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 entity's overall activities, and might not jeopardize the nonprofit's exempt status. However, the IRS could logically argue that, in cases in which a for-profit partner controls die joint venture (through the partnership agreement or other arrangement placing operational and policy control in the for-profit partner's hands), any income allocable to a nonprofit profit should be treated as unrelated business income.

Thus, the definition of control that ultimately develops through the St. David's 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