A partnership arrangement that consolidates the management of two not-for-profit hospital systems won't result in any tax problems for the systems, according to a new ruling by the Internal Revenue Service.
The ruling is the first to address the tax consequences of a joint operating agreement between not-for-profit hospitals. Such agreements are becoming more popular as hospitals seek ways to capture market share short of merging or acquiring another facility. In such partnership arrangements, the hospitals maintain separate ownership and assets but coordinate operations through a common board.
The private letter ruling is dated Nov. 22, 1995. The IRS has yet to release it publicly, but the hospitals' attorney made it available to MODERN HEALTHCARE.
The ruling doesn't identify the hospitals involved in the partnership, and the hospitals, through their attorney, declined to be identified. One system operates three hospitals in three cities. The other operates one hospital in a fourth city.
Under the deal addressed in the ruling, the systems formed a not-for-profit partnership governed by a common board. They held separate their existing assets and ownership structures, but they became financially linked through two annual payment arrangements.
In the first, the systems essentially share profits. The system that earns a higher profit gives 50% of the difference between its profit and the other's profit to the lower-earning system. In the second, the systems share new capital expenditures. The system that spends less on new capital gives 50% of the difference between its capital expenses and the other's expenses to the higher-spending system.
The key question before the IRS was whether the joint operating agreement created a partnership, as traditionally recognized under the federal tax code. That's defined as an organization separate from its partners and formed solely for the benefit or private use of the partners. If so, the hospitals' existing tax-exempt bonds could be taxable, and the money systems exchanged through their two annual payments could be considered taxable unrelated business income.
But in its eight-page decision, the IRS said the arrangement posed no adverse tax consequences for the systems.
The IRS concluded that the systems essentially became a single organization through the deal, and the partnership structure was secondary to what the systems were trying to do. Consequently, the systems' tax-exempt bonds were safe because no separately acting partnership was benefiting from them. And the money that flowed between the systems because of the partnership supported their charitable mission and, therefore, wasn't considered taxable unrelated business income.
Gerald Griffith, an attorney with the Detroit office of Honigman Miller Schwartz and Cohn, said the ruling is good news for other not-for-profit hospitals that want to pursue partnership arrangements. Griffith, who represented the systems, said the ruling demonstrated the IRS' "flexibility" in reviewing such deals.
Griffith said he doubted the IRS would be so lenient if the joint venture was between a not-for-profit and for-profit hospital or hospital chain.
"It is highly unlikely that the IRS would reach the same conclusion on the bonds today if the joint operating agreement was with a taxable hospital," he said.