The creation of a joint operating company by two not-for-profit hospital systems won't jeopardize the systems' respective tax-exempt revenue bonds, the Internal Revenue Service said last week in a tax ruling.
The ruling is just the second regarding hospital joint operating agreements, which are becoming an increasingly popular method of hospital market consolidation.
"The joint operating concept is so fluid right now, the more rulings we have on this issue, the better," said Michael Peregrine, a healthcare tax attorney with Gardner, Carton & Douglas in Chicago.
Joint operating agreements allow hospitals to increase their market share but avoid the political fallout that may result from differences in ownership, assets, governance and corporate culture. In such deals, two or more hospitals typically form a company to run the hospitals as a single merged organization but each maintains its separate ownership and assets.
Although the new ruling offers important tax guidance for hospitals pursuing such a strategy, the two hospital systems that are the subject of the new ruling parted ways earlier this year.
The systems are Community Hospitals of Indianapolis and St. Vincent Hospital and Health Care Center in Indianapolis. Community operates three acute-care hospitals, and St. Vincent operates two.
Under a joint operating agreement signed by the systems in December 1993, the systems consolidated their operations under a 16-member board of directors with equal representation from both systems.
After a brief antitrust investigation by the U.S. Justice Department, the systems began putting their network together in March 1994. But less than two years later, the network broke up, citing an inability to develop a single leadership structure and to reconcile differing management and operating styles (Feb. 5, p. 8).
The new ruling doesn't identify the hospital systems, but three sources, who requested anonymity, confirmed that the Indianapolis systems are the ones addressed in the new IRS ruling. Also, a complex formula used by the Indianapolis systems to share profits based on past financial performance matched the formula discussed by the IRS in its new ruling.
Jim Dobson, Community's general counsel, declined to confirm that his system was the subject of the ruling. Spokesmen for St. Vincent didn't respond to interview requests.
The ruling is a six-page private letter ruling, No. 9623011. It's dated Feb. 29, but the IRS didn't release it publicly until last week.
The issues before the IRS were whether the systems' new not-for-profit joint operating company would strip the systems' respective revenue bonds of their preferred tax-exempt status and whether money exchanged by the systems through the new company would be considered taxable unrelated business income.
The bonds could be at risk if the new corporation, or partnership, acted as a separate organization with separate business interests rather than representing the mutual interests of the partners. And if it was a separate organization, the money exchanged by the systems through the new corporation could be taxable unrelated business income.
But the IRS said no on both counts. It said the new corporation essentially was an extension of both systems and, consequently, there were no adverse tax risks. It said the systems were financially and structurally linked through the new corporation, which furthered the charitable purposes of both organizations.