A rural hospital management company with ties to VHA may lose its federal tax exemption because, according to the Internal Revenue Service, there's nothing charitable about operating a hospital under contract.
The IRS' move to revoke the company's tax status came to light last week when the agency publicly released a "technical advice memorandum" outlining the action against the not-for-profit corporation.
Technical advice memoranda explain how the law should be applied to particular facts in an audit, usually issued by the IRS' national office to an agency field office.
The legal memorandum, which is dated Nov. 10, 1997, doesn't identify the hospital management company, but MODERN HEALTHCARE has learned that it's the Great Plains Health Alliance, based in Phillipsburg, Kan.
Great Plains executives confirmed last week that their 48-year-old organization is the target of the precedent-setting IRS revocation action.
Great Plains manages or leases 26 small rural hospitals in Kansas and Nebraska (See chart).
The case against Great Plains is significant for a number of reasons:
It's one of only four revocation proceedings against a hospital or hospital operator in the past 20 years. The closest the IRS has come in recent years was a revocation proceeding against the former owners of a Florida hospital that had been out of business for four years (Oct. 31, 1994, p. 2).
It calls into question the tax exemptions of any not-for-profit corporation that manages or leases hospitals.
And it contradicts the not-for-profit hospital sector's often-heard rhetoric, led by VHA, that struggling hospitals should link with not-for-profit organizations because they, rather than for-profits, only want to serve their communities.
In its 15-page memorandum, the IRS said managing hospitals is "an ordinary business undertaking" with no charitable purpose.
Specifically, the IRS said Great Plains doesn't deserve to keep its decades-old tax exemption, because the company does not directly provide any healthcare services itself.
Great Plains' "overall activities are scarcely distinguishable from similar activities of an ordinary commercial enterprise," the IRS said.
The IRS memorandum cited the following reasons for reaching that conclusion:
Great Plains does not own any hospitals; it only leases or manages them for a fee.
Great Plains does not accept any responsibility for the ultimate provision of care and delivery of healthcare services. That remains the duty of the county or hospital district that owns the facility.
Great Plains does not provide "essential" services to the hospitals it manages or leases, and the fees it charges for these services are "sufficient to cover its costs and provide a reasonable reserve." That reserve does not go into the hospitals or their communities, the IRS contends.
The individual hospitals, not Great Plains, employ physicians, nurses and other care providers. Great Plains' primary employees are hospital administrators and financial and accounting personnel.
All that makes Great Plains a for-profit company, according to the IRS.
Ironically, Great Plains is a member of VHA, a not-for-profit hospital alliance based in Irving, Texas.
Under a contractual arrangement with VHA, any hospitals managed or leased by Great Plains become VHA members.
VHA spokesman Mack Haning was informed of the IRS' decision by MODERN HEALTHCARE and said the for-profit alliance will not be affected.
An IRS spokesman declined to comment on the case against Great Plains.
But Great Plains is fighting back.
On June 1, the company filed a petition contesting the IRS' decision in U.S. Tax Court in Washington, after exhausting its options for administrative remedies.
In its petition for a declaratory judgment, Great Plains argues it is a de facto hospital by virtue of the terms of its lease agreements with 10 hospitals. It has management contracts with 16 other hospitals. In essence, it does perform a charitable service by providing hospital care.
The company further claims it is entitled to the exemption because it is "devoted to improving hospital services in rural areas," the petition said. Most of Great Plains' affiliated hospitals are county-owned facilities with fewer than 50 beds. Thirteen of the hospitals are in medically underserved counties or areas HHS has designated as having health professional shortages.
The company traces its roots to the American Lutheran Church, which saw a need to provide management services and administrative support to small, public hospitals. Great Plains was formed in 1950 as Great Plains Lutheran Hospitals Inc. because of the church's interest in rural healthcare.
Great Plains "was engaged in providing essential services to its rural constituency long before such services were generally offered by commercial organizations," the company's petition said. "It was born in response to perceived community health needs, not out of a desire for profit."
Great Plains first received its IRS exemption in 1956, and that status was reaffirmed in 1984 after Great Plains merged with Community Health Alliance, a group of hospitals formerly affiliated with Wesley Medical Center in Wichita, Kan. Wesley was bought in 1984 by Hospital Corporation of America, which is now part of Columbia/HCA Healthcare Corp.
The IRS is expected to file a response to Great Plains' petition soon. Both sides will then present oral arguments in tax court before a judge, who will rule on the petition.
The present brouhaha began with a routine IRS audit of Great Plains' pension funds three to four years ago, said Roger John, president and chief executive officer of Great Plains.
The agency then requested information about other aspects of the company's operations, culminating in a March 2 final adverse determination letter to Great Plains stating that its exemption would be revoked effective that day.
In an unusual move, the IRS chose to revoke Great Plains' exemption prospectively, meaning the company must pay income taxes from this year on. The agency has the right to revoke an exemption prospectively or retroactively, which means the once-exempt organization owes back taxes for years past. A retroactive revocation is considered punitive and usually occurs only when the IRS discovers an organization has engaged in egregious behavior, attorneys said.
Recognizing that retroactively revoking the organization's tax-exempt status back to the 1950s and assessing it millions of dollars in back taxes and fines would likely put it out of business, the IRS used its discretion to make the revocation prospective.
"It seems like it's only a fair thing to (revoke the exemption prospectively), since IRS had affirmed the exempt status before," said Elizabeth Mills, a healthcare tax attorney at McDermott Will & Emery in Chicago. "What probably happened was that the IRS conducted an audit and discovered it had misunderstood or not gone into deeply enough what the organization was doing. That's probably why they revoked it prospectively and not retroactively."
Administrators of several hospitals under the Great Plains umbrella told MODERN HEALTHCARE they were surprised by news of the revocation-especially since Great Plains enjoyed the exemption for more than 40 years with no known problems.
However, the administrators are not
worried, because the IRS' decision will not directly affect their facilities or their exemptions.
"We operate our own financials here and file our own return (with the IRS)," said Ronald Baker, administrator of 38-bed Kiowa County Memorial Hospital in Greensburg, Kan., which signed a lease agreement with Great Plains last fall. "This (revocation) isn't significant for us because of the way (Great Plains) operates hospitals independently under the lease."
According to Great Plains' latest annual tax filing with the IRS, known as Form 990, the company reported 1996 revenues of $2.3 million. That figure does not include revenues from the 10 lease arrangements.
But the relative independence that hospitals find appealing about their lease agreements with Great Plains may be what led the IRS to revoke the company's exemption. Without substantial control of operations and responsibility for profits and losses, Great Plains does not qualify as a healthcare provider and, therefore, doesn't meet exemption requirements, the IRS said.
"The IRS told us that the leases did not show enough control over the leased facilities," Great Plains' John said.
Several not-for-profit chains that also manage hospitals said the IRS' decision was nothing new. In fact, these chains set up their management businesses as separate for-profit subsidiaries, believing that was what the law required them to do.
"Management services are not a tax-exempt activity and never have been," said Alan Broude, senior vice president and chief financial officer at Jewish Hospital HealthCare Services in Louisville, Ky., which manages five hospitals. "That's why our hospital management services are provided through a taxable subsidiary. There's nothing charitable about providing management services."
Attorney Mills added: "This is not a new legal conclusion and reaffirms what the IRS' position has been for a long time. General counsel memoranda have said that management organizations that are part of systems would either not qualify for exemption because they do business outside the organization or they should have their exemptions revoked."
Like Jewish, Carilion Health System in Roanoke, Va., and Alliant Health System in Louisville also have separated their management businesses into for-profit subsidiaries.
"This (memorandum) appears to be a clearer statement of what people already thought the IRS' policy was," said Tad Myre, general counsel for Alliant. "With few exceptions, the IRS has said that (management services) constitute unrelated business income (that should be taxed)."
VHA itself last year formed VHA Southwest Community Health, a not-for-profit company that aims to acquire, lease or manage tax-exempt hospitals in New Mexico and Texas to prevent them from becoming for-profit.
Michael Williams, president and chief executive officer of VHA Southwest Community Health, said his company's tax exemption should be safe because the hospital agreements will call for the firm to accept financial risk.
"In our application to the IRS for tax-exempt status, we were asked many questions about whether we would acquire (tax-exempt) hospitals or just lease and manage them," Williams said. "We are accepting financial responsibility for that facility and will operate it, not just manage it. Our real focus is community benefit, unlike other companies."