Not-for-profit hospitals can't extend their tax-exempt status to joint ventures with physicians or for-profit companies if the hospitals cede too much control to the private interests, a federal tax court has ruled.
The 83-page opinion, rendered last week by a U.S. Tax Court judge in Washington, may force not-for-profit hospitals across the country to restructure their ancillary-care joint ventures with physicians or for-profit partners if they want to avoid being hit with past-due tax bills.
"This will change the way (these ventures) are put together, the organizational structure and how the transactional documents are prepared," said Thomas Hyatt, a healthcare tax lawyer with the Washington office of Ober, Kaler, Grimes & Shriver.
Hyatt and others said many not-for-profit hospitals have included "bailout" clauses in their joint venture contracts specifically in anticipation of the case decided last week. Those clauses will allow the hospitals to restructure the joint ventures to comply with the ruling.
The case decided by the tax court last week was a joint venture between a not-for-profit hospital and a for-profit outpatient surgery company.
Not-for-profit Redlands (Calif.) Health Systems, the parent company of 194-bed Redlands Community Hospital, and for-profit Surgical Care Affiliates of Nashville partnered in 1990 to buy 61% of a profitable ambulatory surgery center, Inland Surgery Center, for $3 million.
A group of 30 physicians on staff at Redlands Community Hospital and Beaver Medical Clinic, also in Redlands, opened the Inland center in 1983 and continue to hold a 39% stake in it.
SCA controlled 63% of the partnership with Redlands Health Systems. The general partnership they formed was called Redlands Ambulatory Surgery Center.
Redlands Health Systems' stake in that partnership then formed a corporation called Redlands Surgical Services. That subsidiary applied to the IRS for a tax exemption, even though its sole activity was participating as a co-general partner with a for-profit corporation.
It was that relationship that the tax appeals court questioned.
Doug Mancino, a healthcare tax lawyer who represents the partnership, said the venture deserved tax-exempt status because of how it functioned, regardless of who controlled it.
"The real test was how the surgery center operates. And if it operates in the manner of a charitable operation, which we believe it does, then control is not a relevant issue," Mancino said.
The IRS disagreed and denied the partners' tax-exemption request in 1996.
The IRS said Redlands Health Systems ceded control of the joint venture and its operations to its for-profit partners and said Redlands failed to prove its "integral-part doctrine" case.
In 1997, Redlands Health Systems appealed the decision to U.S. Tax Court, which reviewed briefs through May 1998.
In his decision last week upholding the IRS' ruling, Judge Michael Thornton said Redlands Surgical Services is not operated exclusively for charitable purposes, because it benefits private parties, such as its physicians and for-profit partners, and fails to benefit a broad cross-section of the community.
"The facts remain that the Surgery Center provides no free care to indigents and only negligible coverage for Medi-Cal (California Medicaid) patients," Thornton wrote.
While HealthSouth Corp. purchased Surgery Care Affiliates in 1997, Redlands Health Systems remains the other general partner in the joint venture clinic, which continues to operate under the same name. The clinic began paying federal back taxes after the 1996 IRS denial and has operated as a for-profit corporation since the initial 1990 ruling by the IRS.
Redlands Surgical Services can appeal the tax court's decision to federal appellate court. Mancino said the Redlands Health Systems board will make that decision next month.