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Hospital's joint venture with its medical staff could jeopardize exempt status.

Tax-exempt hospital H proposed to establish a for-profit stock corporation for certain purposes that would be jointly owned in equal shares by H and physicians on its medical staff. The new corporation would in turn establish and serve as the general partner in four limited partnerships (LPs). The LPs were to be formed to allow medical staff physician participation in the operation of four H outpatient departments. The four departments, Outpatient Surgery, Outpatient Diagnostic (CT Scan, Ultrasound, etc.), Ophthalmology and Cardiac Nuclear Medicine, represented in the aggregate about 4% of H's gross revenues.

H stated that it would "in effect, lease the individual departments for a limited time period to the limited partnership[s]." Apparently, the LPs would pay H an actuarially establish price (discounted to present value) for the revenue stream of each of the subject departments. In addition, the LPs would pay H a fee for managing the facilities and reimburse the hospital for all fixed and variable costs incurred in operating the departments. Thus, according to H, physician-investors would benefit only if use of the facilities increased because, in effect, they shared only in profits over and above the level H already received.

H represented that it would retain, through its interest in the for-profit corporation, an interest in each LP. Fifty percent of each LP would be held by the corporation and 50% sold to medical staff physicians. H also stated that it would retain actual control of the facilities through a management agreement, and that it alone would determine the rates charged patients for services in those facilities.

The stated reason for the proposed transactions was to maintain or increase use of H's various services, both inpatient and outpatient, so that it could provide the highest level of service at the lowest price to the public. H argued that failure to undertake the proposed transaction would raise a probability that it would be unable to continue providing the same high level of service to the community so, it reasoned, the transaction should be viewed as furthering its charitable purposes.

H maintained that the ventures would help it by creating incentives for medical staff physicians to increase inpatient admissions. The ventures would also create incentives for medical staff physicians to increase referrals to ancillary departments. These factors, combined with a feared loss of outpatient department business to competitors if the ventures were not undertaken, led the hospital to believe it would be better off by proceeding than by not doing so.


The joint venture arrangements described are just one variety of an increasingly common type of competitive behavior engaged in by hospitals in response to significant changes in their operating environment. Many medical and surgical procedures once requiring inpatient care, still the exclusive province of hospitals, now are performed on an outpatient basis, where every private physician is a potential competitor. The marked shift in governmental policy from regulatory cost controls to competition has fundamentally changed the way all hospitals, for-profit and not, do business.

Whenever a charitable organization engages in unusual financial transactions with private parties, the arrangements must be evaluated in light of applicable tax law and other legal standards. Like any hospital-physician joint venture, the sale of revenue stream transactions described above must be carefully scrutinized. We believe the transactions described must be viewed as jeopardizing a hospital's tax-exempt status for three reasons: they allow inurement of part of a charitable organization's net earnings to the benefit of private individuals; they confer more than incidental benefits on private interests; and they may well violate federal law.

Sale of the revenue stream

from a hospital activity

allows net profits

to inure to the benefit

of physician-investors

Sec. 501(c)(3) describes as charitable only an organization "no part of the net earnings of which inures to the benefit of any private shareholder or individual." Similarly, Regs. Sec. 1.501(c)(3)-1(c)(1) provides that an organization is not operated exclusively for one or more exempt purposes, as is required for exemption, if its net earnings inure in whole or in part to the benefit of private shareholders or individuals.

The proscription against inurement generally applies to a distinct class of private interests -- typically persons who, because of their particular relationship with an organization, have an opportunity to control or influence its activities. These individuals are often referred to informally as "insiders."

Despite this limitation, the class of persons properly viewed as private shareholders and individuals (i.e., insiders) can, under certain circumstances, be sizeable.

While most physicians on the medical staffs of the subject hospitals presumably are not employees and do not provide any compensable services directly to the hospitals, they do have a close professional working relationship with the hospitals. The physicians have applied ro and been granted privileges to admit and treat their private patients at the hospital. They are bound by the medical staff bylaws, which may be viewed as a constructive contract between them and the hospital. Individually, and as a group, they largely control the flow of patients to and from the hospital and patients' use of hospital services while there. Some may serve other roles at the hospital, such as that of part-time employee, department head, board member, etc. Moreover, once the arrangements at issue commenced, each physician-investor became a joint venture partner of the hospital or an affiliate.

Even though medical staff physicians are subject to the inurement proscription, that does not mean there can be no economic dealings between them and the hospitals. The inurement proscription does not prevent the payment of reasonable compensation for goods or services. It is aimed at preventing divident-like distributions of charitable assets or expenditures to benefit a private interest. If physicians were hospital employees, payment to them of reasonable salaries and benefits would not give rise to inurement. Similarly, if physicians were independent contractors providing needed services to (or on behalf of) a hospital, payment of reasonable compensation for those services would not give rise to inurement.

The presence of a percentage compensation arrangement will destroy an organization's exemption if it transforms the principal activity of the organization into a joint venture between it and a group of physicians or is merely a device for distributing profits to persons in control. Also, if salaries or total compensation are not reasonable, they will result in inurement.

It should be noted that the inurement prohibition, while stated in terms of the net earnings of an organization, applies to any of a hospital's charitable assets. It applies to more than just the net profits shown on the books of the organization or the surplus of gross receipts over disbursements in dollars. Similarly, net earnings may inure to the benefit of an individual in ways other than through the distribution of dividends. Equally important, inurement may be found are small. There the amounts involved are small. There is no de minimis exception to the inurement prohibition.

The proper starting point for our analysis of the net revenue stream arrangements is to ask what H gets in return for the benefit conferred on the physician-investors. Put another way, we ask whether and how engaging in the transaction furthers H's exempt purposes. Here, there appeals to be little accomplished that directly furthers H's charitable purposes of promoting health. No expansion of health care resources results; no new provider is created. No improvement in treatment modalities or reduction in cost is foreseeable. We have to look very carefully for any reason why a hospital would want to engage in this sort of arrangement.

Assuming that H did have a pressing need for an advance of cash, we could examine this type of transaction strictly as a financing mechanism. It certainly is permissible for a Sec. 501(c)(3) hospital to borrow funds against future earnings; in fact, they often use tax-exempt bonds to borrow at favorable interest rates. Nevertheless, we do not believe it would be proper under most circumstances for a charitable organization to borrow funds under an agreement, even with an outside commercial lender, where the organization would pay as interest a stated percentage of its earnings. While doing so might not constitute inurement if an outside lender were involved, it would if the lender were, as here, an insider.

Whether admitted or not, we believe that H engaged in these ventures largely as a means to retain and reward members of its medical staffs; to attract admissions and referrals; and to preempt the physicians from investing in or creating a competing provider. Giving (or selling) medical staff physicians a proprietary interest in the net profits of a hospital under these circumstances creates a result that is indistinguishable from paying dividends on stock. Profit distributions are made to persons having a personal and private interest in the activities of the organization and are made out of the net earnings of the organization. Thus, the arrangements confer a benefit that violates the inurement proscription of Sec. 501(c)(3).

REFLECTIONS: Similarly, the Service felt that a direct and substantial incidental private benefit accrued to H's physician-investors. While incidental private benefit (both qualitatively and quantitatively) may occur, and indeed some private benefit is found in all hospital-physician relationships, H's arrangement exceeded "the bounds of prohibited private benefit."

Anti-kickback law. Such arrangements may also violate the Medicare and Medicaid Anti-Fraud and Abuse Law, which prohibits any remuneration in return for or to induce referral of patients. While physician ownership of a provider to whom he makes referrals is not per se illegal, providing an opportunity to invest in a profitable venture might rise to the level of prohibited "remuneration" made in return for referrals.
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Article Details
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Author:Fiore, Nicholas J.
Publication:The Tax Adviser
Date:Feb 1, 1992
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