To qualify as a tax-exempt organization under the federal tax codes, hospital joint operating companies must be more than just shell organizations through which not-for-profit hospitals gobble up market share and split the spoils, the Internal Revenue Service says.
In its latest training manual for federal tax auditors, the IRS says the activities of a joint operating company must be significantly linked to the operations of its member hospitals to derive its tax-exempt status from the hospitals.
The annual document, known as the Continuing Professional Education Technical Instruction Program, does not carry the legal weight of tax law. But it does tell IRS agents what to look for when they audit tax-exempt organizations, including not-for-profit hospitals. It reveals the IRS' thinking on the latest business transactions in the healthcare industry and provides important tax policy guidance to not-for-profit healthcare providers.
The new manual, released by the IRS late last month, includes a chapter on what the agency is calling "virtual" hospital mergers through the creation of joint operating companies.
Joint operating agreements have become an increasingly popular form of consolidation among hospitals that want to coordinate their operations without giving up their historic assets or ownership structures. Hospitals in this scenario typically form a third organization, a joint operating company or common board, to oversee the activities of the individual hospitals.
Such agreements raise several tax questions for not-for-profit hospitals. For example, if a joint operating company were a separate for-profit organization with separate business interests rather than a company representing the mutual charitable interests of the hospitals, the hospitals' tax-exempt financing could be at risk. And, if the joint operating company were a separate organization, the money that flows through the company to and from the hospitals could be considered taxable unrelated business income.
"That's why it's important for the hospitals to have their joint operating company qualify for tax-exempt status," said Elizabeth Mills, a tax attorney with McDermott, Will & Emery.
Ideally, the joint operating company should qualify for its exemption based on the fact that its activities support and further the charitable mission of the partnering hospitals, she said.
In its new audit manual, the IRS set out a map for hospitals to do just that.
The IRS said a joint operating company can derive its tax exemption by being an "integral part" of the charitable operations of the sponsoring not-for-profit hospitals. The joint operating company must meet three criteria, including assuming many key functions from the hospitals (See chart).
The IRS then identified nine functions that it would like to see the hospitals give up to the joint operating company. They include the authority to establish budgets, set or approve fees and prices, and hire and fire personnel.
The IRS said it is not enough for the hospitals simply to give final veto power over decisions to the joint operating company. It must have the authority to initiate a decision or action. Conversely, the sponsoring hospitals cannot have veto power over the decisions of the joint operating company, the IRS said, because that would indicate that the joint operating company has no real authority over the hospitals.
Meanwhile, the same IRS manual included the expected section allowing not-for-profit hospitals to appoint more physicians to their governing boards. A draft of the section leaked out of the IRS in July (July 8, p. 4).
Under a new policy outlined in the manual, not-for-profit hospitals can hand over as much as 49% of their boards to physicians and other insiders, including officers, department heads and other employees. The majority, or 51%, must still be independent community members.
Previously, the IRS had no test regarding how board seats must be apportioned. Generally, not-for-profit hospitals were considered safe if physicians and other insiders controlled 20% or less of their boards. The limit was designed to ensure that hospitals operated for the benefit of the community rather than for the private interest of individuals like physicians.
More important, the IRS in its new manual said it does not matter how many seats an affiliated organization gives to physicians as long as the organization ultimately is controlled by a not-for-profit organization whose own board has a majority of independent community members holding its seats. The new policy will allow hospitals to turn over the governance of affiliates and subsidiaries, such as physician-hospital organizations, completely to doctors without jeopardizing their tax-exempt status.
"This relaxed policy represents a substantial benefit to hospitals seeking closer integration with physicians," said Michael Peregrine, a healthcare attorney with Gardner, Carton & Doug-las in Chicago. "It may provide not-for-profits with additional competitive leverage over investor-owned hospitals, which tend to limit physician participation in governance."
However, hospitals can take advantage of the liberalized rules on physician governance only if they adopt a conflict-of-interest policy to protect the hospitals' interest in deals that also may benefit a physician's or insider's private interests.
The IRS also provided a model conflict-of-interest policy in the manual that hospitals would be wise to adopt, Peregrine said.