As the healthcare industry awaits a promised Internal Revenue Service ruling on joint ventures between for-profit and not-for-profit hospitals, a tax case out of California hints at what might come.
The case indicates that the extent of control a not-for-profit has over the joint venture might determine if the venture also will be considered not-for-profit in the eyes of the IRS. The case suggests the IRS won't extend tax-exempt status to the venture unless the not-for-profit involved controls its revenues and assets.
"That seems to be the guidepost they're setting up," said Harry Friedman, an attorney with Steel Hector & Davis in Miami. "You have to have control of an organization in order to mandate that it operates in a charitable way."
The case that's giving attorneys this early warning involves Redlands (Calif.) Surgical Services, a joint venture corporation denied tax-exempt status by the IRS in 1995 and again in 1996.
The confidential tax dispute became public last month when Redlands appealed the IRS' denial to the U.S. Tax Court in Los Angeles, where the case is pending.
Redlands Surgical is a joint venture formed by the parent corporation of 194-bed Redlands Community Hospital, a not-for-profit, and Surgical Care Affiliates, a Nashville-based for-profit chain of outpatient surgery centers. For-profit HealthSouth Corp. acquired Surgical Care earlier this year.
The joint venture runs an outpatient surgery center, called Inland Surgery Center, in Redlands. Surgical Care, now HealthSouth, manages Inland under contract.
A key issue in the IRS' denial of tax-exempt status was Redlands' lack of control over the partnership and surgery center. The IRS also said Redlands was in the venture only to make money.
The IRS' analysis is what tax attorney T.J. Sullivan called a "looking glass" into the future.
"I think this is a very significant tax-exempt organizations case," said Sullivan, a former attorney in the IRS' tax-exempt organizations division who is now with Gardner, Carton & Douglas in Washington.
Doug Mancino, an attorney for Redlands, disagreed. "I think people are overstating the significance of (the case)," said Mancino, of McDermott, Will & Emery in Los Angeles.
He said the case of a freestanding ancillary service doesn't compare to whole-hospital joint ventures. He also disputed the IRS' findings.
"The IRS is wrong because we do have a voice in governance of the organization," Mancino said.
Marcus Owens, director of the IRS' exempt organizations division, declined to comment on the matter, although attorneys said he has highlighted the case to them. A HealthSouth spokeswoman also declined to comment on the lawsuit.
The IRS spelled out its problems with the joint venture in an April 1996 determination letter.
It said Redlands lacked sufficient control over the joint venture because there is an equal split in governance of the partnership and because day-to-day management of the surgery center is handled by a for-profit company. That, according to the IRS, is in "direct conflict with achieving charitable goals."
"A charitable organization may enter into business relationships with for-profit entities without violating the private-benefit test so long as the charity retains control over the income and the assets necessary to carry out its charitable functions," the letter said. "However, if the arrangement is structured so that the charity is not in control, such arrangement will generate impermissible private benefit."
The IRS noted that Inland doesn't perform charity care and less than 1% of its patients were Medicaid beneficiaries.
In addition to citing the control issue, the IRS also said the joint venture failed the so-called "integral part" theory.
The theory has been used by not-for-profit providers to win tax-exempt status for joint ventures and other businesses by arguing the ventures are integral to their charitable mission.
The IRS said the integral-part argument didn't apply because the joint venture operated for the benefit of private entities, namely the for-profit company involved and the physicians who also invested in it.
The IRS said any revenues Redlands received through the venture would be taxable as unrelated business income.
Jim Holmes, chief executive officer of Redlands Community Hospital, said he's perplexed why the IRS is hassling his hospital about a venture that lowers the cost of care by keeping people out of the hospital. He said the IRS has approved similar joint ventures in the past and he's confident that the hospital and joint venture will prevail on appeal.