Effectively ending a five-year court battle, a federal appellate court has denied tax-exempt status to a California surgery center co-owned by a not-for-profit hospital. The long-awaited ruling has national implications for any not-for-profit hospital doing joint-venture business with a for-profit partner.
The 9th U.S. Circuit Court of Appeals in San Francisco last week upheld a 1999 ruling by the U.S. Tax Court that said not-for-profit hospitals couldn't extend their tax-exempt status to joint ventures with physicians or for-profit companies if the hospitals ceded too much control to the private interests.
The case involves not-for-profit Redlands (Calif.) Health Systems, the parent company of 194-bed Redlands Community Hospital and for-profit Surgical Care Affiliates of Nashville, which is now owned by HealthSouth Corp., Birmingham, Ala. Redlands Health Systems and the SCA teamed up in 1990 to buy 61% of an existing 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 continues to hold a 39% stake in it.
The 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.
The IRS denied the providers' exemption request in 1996, saying for-profit interests controlled too much of the joint venture. The IRS also rejected the providers' "integral part" argument, which said the joint venture should be tax-exempt because it was an integral part of the not-for-profit hospital's charitable mission.
In an 83-page decision, the U.S. Tax Court upheld the IRS' determination (July 26, 1999, p. 8), and Redlands Surgical Services appealed the decision to the 9th Circuit, which heard oral arguments on March 5.
In a swiftly issued one-paragraph ruling, a three-judge panel of the 9th Circuit affirmed the tax court's decision. The IRS' refusal was based on regulatory guidance known as Revenue Ruling 9815, which states that a not-for-profit partner must exert real control over a joint venture with a for-profit company for the venture to qualify as tax-exempt. Redlands had "ceded effective control over the operations of the partnership and the surgery center to private parties, conferring impermissible private benefit," the tax court said.
The appellate panel's affirmation doesn't prohibit not-for-profit providers from participating in joint ventures with for-profit companies, said T.J. Sullivan, a former IRS official and a lawyer with the Washington law office of Gardner, Carton & Douglas.
"But those ventures need to be carefully structured so that the not-for-profit is able to rely on the activities of the joint venture to support its tax-exempt purposes, or there may be unrelated business income tax implications," Sullivan said.
Redlands Health Systems President and Chief Executive Officer James Holmes said he was disappointed by the decision.
"This case opinion is inconsistent with prior IRS and 9th Circuit rulings," said Holmes, who declined to say whether Redlands would appeal the decision.
Tax lawyers familiar with the case said the appellate decision effectively ends Redlands' legal options. Although an appeal to the U.S. Supreme Court is possible, Redlands would unlikely prevail, they said.