A fledgling hospital network in Cincinnati has become the first hospital joint operating company to receive a favorable tax ruling from the Internal Revenue Service because of the merits of its operations.
The IRS has yet to make the ruling public, but it surfaced last week among healthcare tax experts.
The ruling outlined for the first time criteria that not-for-profit hospitals in joint operating agreements must meet to keep their tax-exempt status and make their new joint parent corporation tax-free.
"The ruling will provide important tax guidance to hospitals that want to do the same thing," said Elizabeth Mills, a healthcare tax attorney with McDermott, Will & Emery in Chicago. "It's in line with the criteria that the IRS released in the Continuing Professional Education text."
The text, which is a training manual for IRS auditors who review the business deals of not-for-profit hospitals, reflects the same criteria used in the new ruling (Oct. 7, p. 32). The ruling is dated Sept. 24, and the IRS released the continuing education manual for auditors shortly after that.
The ruling addresses plans by four unidentified not-for-profit hospitals to form a joint operating company that would run their facilities as essentially one organization. The JOA approach is becoming an increasingly popular form of consolidation for hospitals that do not want to or cannot merge their ownership structure.
The hospitals discussed in the ruling are four Cincinnati-area facilities: Christ Hospital, Jewish Hospital and the University of Cincinnati Hospital, all in Cincinnati; and the two-campus St. Luke Hospitals in Florence, Ky.
Phil Tempel, executive vice president of the Health Alliance of Greater Cincinnati, the hospitals' joint operating company, confirmed last week that the alliance's hospitals are the subject of the groundbreaking IRS ruling.
Christ and University created the joint operating company in January 1995. St. Lukes joined the group in July 1995, as did Jewish in January of this year.
A plan to convert University into a private not-for-profit institution on Jan. 1 has come under fire from the city of Cincinnati (Nov. 11, p. 4). University executives have said that the conversion is necessary to cede control of the hospital to the alliance.
A 20-member board controls the joint operating company that governs the hospitals. The board has four members from each hospital: three physician members and one at-large member.
In a May 1995 ruling request, the hospitals asked the IRS whether the transaction would jeopardize the tax exemption of the hospitals and the newly formed joint operating company and whether the money that flowed to and from the hospitals through the new company would be considered taxable unrelated business income.
In a detailed 13-page ruling, the IRS said the deal didn't create any tax problems for the hospitals or their new joint operating company.
The IRS said hospitals in such an arrangement do not automatically retain their preferred tax status simply because they were not-for-profits before the new company was formed. The key to retaining exemptions and getting one for the new joint operating company is how the hospitals and operating company relate to each other.
Specifically, the IRS said the joint operating company and the hospitals must have a relationship similar to a parent corporation and its subsidiaries, with the hospitals giving up control to the joint operating company. This ensures that the joint operating company is furthering the charitable purpose of the not-for-profit hospitals because it is performing the functions that the hospitals would have done themselves.
As evidence of the Cincinnati hospitals giving up control to the new alliance, the IRS cited the fact that the alliance controls the hospitals' budgets, contract negotiations with payers, capital expenditures and changes in services. The president and chief operating officer of the alliance also serves as the president and CEO of each hospital. That person is Jack Cook, Christ's former president and CEO.
"The thing that made our case to the IRS was that the individual hospitals passed most of their authority to the alliance," Tempel said. "The retained powers of the hospitals were so limited that it proved to the IRS that full control rested at the alliance level."
Tempel said the IRS did not request any modifications in the hospitals' plan, although they voluntarily consolidated their human resources functions while waiting for IRS clearance.
The existence of the ruling was foreshadowed in a July press release from two law firms that obtained the opinion from the IRS for the Health Alliance of Greater Cincinnati. The law firms boasted of the first-of-its-kind ruling but subsequently declined to identify the hospitals involved or release a copy of the ruling.
The IRS has released two previous rulings on the tax implications of hospital JOAs, but both dealt with the impact of the JOAs on the hospitals' tax-exempt bonds. The new ruling is the first to address the tax implications for hospitals and joint operating companies themselves.