Tax Exempt Issues for Rural Integrated Systems

by Jim Teevans, J.D.

Many of the DRIS sites have chosen to pursue tax-exempt status for their Administrative Service Organizations or "integrated health systems." Already, Lompoc Valley Community Healthcare Organization has received federal tax-exemption. Both the Imperial Valley Community Health Organization and Sierra CommCare in the Indian Wells Valley have applied for tax-exemption. These integrated systems propose to engage in charitable activities as well as related business activities. The purpose of this article is to discuss approaches for tax-exempt 501(c)(3) integrated health systems to help ensure that they are able to meet their charitable purpose requirements. This information is also important for tax-exempt organizations participating as governing board members in order to ensure that they too do not lose their own tax-exempt status or face sanctions because of their participation in the integrated health system organization. The following provides insight to the Internal Revenue Service's (IRS) assessment of the issues relating to tax-exempt status for integrated health systems and offers some recommendations for meeting IRS guidelines.

Tax-Exemption for Rural Integrated Health Systems

Some integrated health systems that include tax-exempt organizations are interested in finding out whether their integrated health system can obtain tax-exempt status. To answer this question, integrated health system participants must first determine whether their integrated health system's activities and purposes truly are exempt under IRS statutes, rules, and regulations.

Often healthcare providers and other exempt organizations in rural areas are exempt under Section 501(c)(3) of the Internal Revenue Code. Section 501(c)(3) provides, in part, for the exemption from federal income tax of entities organized and operated exclusively for charitable, scientific, or educational purposes, provided that no part of the organization's net earnings inures to the benefit of any private shareholder or individual.

IRS regulations provide that the term "charitable" is applied in its generally accepted use.¹ The promotion of health has long been recognized as a charitable purpose, including providing health education, improving access to care and studying and implementing ways to resolve health problems. Rural integrated health systems seeking to provide or enhance health promotion activities are likely to obtain exempt status. However, the real test for tax-exemption is the promotion of health in addition to something more. To distinguish a charitable entity from one that merely provides a service for private benefit, the IRS will look to see whether services are offered to all people regardless of ability to pay, for example, among other indicators of a "charitable" purpose. Such charitable activities or services should benefit a broad cross section of the community.

Thus, to obtain tax-exempt status, integrated health systems need to:

Document the clear charitable purposes of the integrated health systems early in the formation process (e.g., providing care regardless of a person's ability to pay, access to members of public (Medicare and Medicaid) managed care programs, and engaging in health promotion and disease prevention activities);
Create a governing board that is broadly representative of the community; and
Ensure that charitable purposes outweigh profit maximization purposes in the long term.

Lompoc Valley Community Healthcare Organization (LVCHO) of Santa Barbara County, California, a participant in the DRIS Initiative, recently received tax-exempt status as a 501(c)(3) by establishing its charitable intentions. The integrated health system includes the local 60-bed district hospital, an independent physicians association (involving most of the primary care physicians and specialists in town) and several community and political leaders. The LVCHO explained to the IRS that the integrated health systems sought jointly to increase access, improve quality of care and lower costs to all people in the Lompoc area. In particular, the LVCHO outlined their intent to study ways to expand care to the indigent population. The LVCHO proposed, among other things, to develop continuing education programs for the public and providers, to define and implement clinical pathways, to combine administrative (management) services, and to coordinate disease prevention and health promotion activities. The Lompoc integrated health system emphasized the charitable as well as administrative characteristics of the integrated health systems.

Integrated health systems that focus solely on providing administrative support services, such as claims processing, management, consulting, and other third party administrator services, will have difficulty obtaining tax-exempt status unless they promote charitable functions as well. The IRS and courts regularly have held that the provision of management services to unrelated exempt entities in exchange for a fee sufficient to produce a small profit does not on its own further exempt status.² A recent pronouncement by the IRS stating that Great Plains Health Alliance (a rural hospital management company that provided services for tax-exempt hospitals) was not itself tax-exempt, further confirms the difficulty for integrated health systems seeking exempt status for administrative support functions.³

In addition, in December 1998, the IRS revoked the tax-exemption for an HMO owned by Intermountain healthcare⁴ after it determined that the HMO did not provide a charitable community benefit. The HMO did not provide emergency care and did not treat non-enrollees. It is important for rural integrated health systems seeking tax-exemption to define and pursue a charitable purpose.

Integrated Health Systems and Tax-Exempt Participants

The tax-exempt status of the integrated health system is often important to maintaining the tax-exempt status of individual ASO or Community Health Organization members. Integrated health systems that involve tax-exempt entities must be aware of IRS requirements that may pertain to these entities. Because rural integrated health systems can involve both tax-exempt and for-profit participants, the IRS seeks to ensure that the formation and operation of an integrated health system does not violate tax-exemption rules and regulations. IRS oversight affects how tax-exempt dollars are controlled and used within the system structure. It also sets parameters for system functions.

Integrated health systems should be sensitive to three key issues that relate to the participation of tax-exempt entities:

To what extent does the governance structure allow a for-profit entity to direct or control charitable assets?
To what extent does the health system's structure and operations allow a person with substantial influence to profit improperly from his or her dealings with tax-exempt entities?
To what extent do the activities of the health system further tax-exempt purposes?

The IRS permits systems integration among healthcare providers, but has cautioned that networking and other integration options need to be tailored carefully so that tax-exempt dollars are not improperly used, particularly as tax-exempt organizations begin to integrate their systems with for-profit entities.

In an IRS educational text for its agents, it recommends that they address the following questions when analyzing integrated health systems or joint ventures between for-profits and tax-exempt entities:

Does participation in the joint venture by the exempt organization further its exempt purpose?
Is the venture required by its governing documents to promote the health of a broad section of the community, and is there actual evidence of such health promotion?
How is the governing board of the venture selected?
Do representatives of the exempt entity who serve on the venture's governing board have a conflict of interest with their ability to represent community interests?
Is there a management firm? How is it selected? How is it paid? What are its duties?
Who sets medical and ethical standards for the venture?

With the development of many types of innovative structures, the IRS has said that it prefers that tax-exempt organizations maintain control over key decisions that impact the use of charitable dollars.⁵

Do the Tax-Exempt Entities Have Control Over Integrated Health Systems' Financial and Charitable Decisions?

The IRS, and state attorneys general, require tax-exempt organizations to provide adequate safeguards so that charitable assets are not used for private benefit. The IRS has cautioned that if a party is allowed to control or use a tax-exempt organization's activities or assets for the benefit of the private party, and the benefit is not incidental to the accomplishment of tax-exempt purposes, the organization will fail to be organized and operated exclusively for tax-exempt purposes.

The following integrated health systems scenarios address issues relating to allocation of control and impact on a party's tax-exempt status.

No Loss of Exempt Status if Tax-Exempt Entities Have Majority Control of Integrated Health Systems' Decisions

The IRS has sought to minimize the "control" of for-profits in any integrated health system or joint venture involving both for-profits and tax-exempt organizations. The IRS has said that it is unlikely to challenge a joint venture in which the for-profit participants have a minority vote in all major decisions by the integrated health systems.⁶

Potential Loss of Tax-Exempt Status if Equal Governance Between the Tax-Exempt and For-Profit Entities

On the other hand, the IRS rejected a hypothetical hospital's integrated health systems structure that merely provides for equal board representation between the two participating hospitals, one tax-exempt and one for-profit. Under this hypothetical situation, the board would have consisted of three representatives of the tax-exempt hospital and three representatives of the for-profit hospital. The IRS found this unacceptable given the fact that with majority decision-making required under the bylaws, the for-profit representatives could block charitable action.

Equal Governance by Tax-Exempt and For-Profit Participants with Community Board Seats

Some rural integrated health systems have sought to limit for-profit control but still have achieved equal governance by adding community representatives to the board. As an intermediate approach between the scenarios above, these added community representatives would not be employed by any of the provider entities (tax-exempt or for-profit) and would not engage in business transactions with the provider entities. This structure could allow for the expectation of equal governance on the part of the for-profit participants while still ensuring that the for-profit participants could not block charitable purposes.

For example, the integrated health systems could be composed of seven board members. Two members could represent tax-exempt entities, two members could represent for-profit entities, and three members could be non-provider community representatives mutually acceptable to the tax-exempt and for-profit entities. Depending upon the number of different interests being brought to the table, the number of total board seats can be increased. It is recommended, for effective and efficient decision-making, however, that the total number not be too great. The important consideration is to minimize the control of for-profit entities over the fate of charitable assets used in the formation and operation of the integrated health systems.

The IRS has not addressed this option. One issue the IRS is likely to raise regarding this is whether, in the absence of super-majority or other rights vested in the exempt organization, the exempt organization has the ability to initiate charitable directives or to ensure that charitable assets are not put at risk. The IRS would also be most interested in knowing the affiliations of any "community representatives."

Equal Governance by Tax-Exempt and For-Profit Participants with Reserved Powers for Tax-Exempt Entities

Another option for rural integrated health systems is to allow for equal governance between the for-profit and tax-exempt entities � without including community representatives � leaving major decision-making with the tax-exempt entity. Thus, with a six member board, three representing the tax-exempt entity and three representing the for-profit entity, certain crucial financial, access, and charity-care decisions can reside solely with the board representatives from tax-exempt organizations. The bylaws can set forth the delegation of decision-making responsibilities and ensure that such tax-exempt decisions override all other integrated health systems decision-making. This option, which the IRS has not yet ruled on, helps to address the concerns raised by the IRS in its previous ruling but does not deviate from the form of equal governance.

Does the Integrated Health System Ensure that Persons with Substantial Influence Over Tax-Exempt Organizations May Not Profit Improperly from Their Dealings with the Tax-Exempt Organizations and Their Integrated Health System?

The IRS has expressed concern that persons with "substantial influence" over tax-exempt entities may improperly benefit from the use of charitable assets. This may involve, for instance, excessive compensation paid by an integrated health system involving a tax-exempt organization to a third person or unfair business dealings between an integrated health system involving a tax-exempt entity and a third party.

In 1996, Congress enacted intermediate sanctions legislation⁷ that resulted in proposed regulations, which were issued by the IRS in 1998. The proposed regulations would allow the IRS to impose penalty excise taxes on insiders who profit improperly from their dealings with tax-exempt entities. Insiders or persons with substantial influence include officers and directors of the organization, substantial contributors, and family members of officers and directors. The IRS will use a fact-based test to assess a person's ability to control or determine a significant portion of an organization's capital expenditures, operating budget or employee compensation. While the regulations focus on tax-exempt organizations, they supply important guidance for integrated health systems involving tax-exempt entities that contribute tax-exempt dollars.

The IRS has recommended the following steps to help minimize liability in this area:

The integrated health systems board or committee establishing compensation should assess fair market value and review comparable data;
Persons with actual or potential conflicts of interest, who could benefit from any decision, should not decide compensation or payment issues; and
Analysis and action should be documented and filed with corporate records.

IRS representatives have stated that tax-exempt organizations should have a process in place and should keep track of documentation. The same recommendation should apply to many transactions involving tax-exempt organizations as well as to integrated health systems involving tax-exempt entities. For example, integrated health systems involving tax-exempt entities should carefully consider and document decisions concerning "gain-sharing agreements," whereby integrated health systems physicians are paid additional sums for meeting cost-savings targets. In the end, sound business judgment reflected in meeting minutes will help protect integrated health systems and their tax-exempt participants.

Do the Integrated Health System's Activities Further Exempt Purposes?

The IRS will also examine whether the rural integrated health system furthers the exempt purposes of the tax-exempt participants. Depending upon the participants' tax-exempt purposes, the integrated health system's articles, bylaws, mission and vision statements, and other organizational documents should demonstrate a commitment to pursuing and achieving such exempt purposes.

Recommendations for Rural Integrated Health Systems with Non-Profit Status

Know which integrated health systems participants are tax-exempt and which are for-profit;
Ensure that contributions from tax-exempt entities are directed solely for the use of tax-exempt purposes (document charitable purpose so integrated health systems participants understand goals and use of integrated health systems funds);
Ensure that tax-exempt entities have control over how tax-exempt dollars will be utilized (either with majority representation on the board or reserved powers over financial matters and other matters impacting the use of tax-exempt dollars, such as selection of officers);
Ensure that integrated health systems participants or third parties are not paid excessive compensation (for example: assess fair market value and review comparable data; directors with a conflict of interest should remove themselves from decision-making; document analysis and decision-making); and
Seek advice from an attorney or the IRS.

Rural providers that form integrated health systems must carefully consider whether tax-exemption is a necessary or viable option considering the new cooperative relationship between for-profit and non-profit participants. While achieving tax-exemption may be possible based on anticipated roles and activities of the network, the difficulty will come in operating both as a charitable organization and as a viable business on an ongoing basis. Rural providers should seek legal guidance in appropriately selecting and documenting charitable activities.

¹ See Internal Revenue Service, Revenue Ruling 98-15 (March 23, 1998) (citing Section 1.501(c)(3)-1(d)(2) of the Income Tax Regulations).

² See BSW Group Inc. v. Commissioner, 70 T.C. 352 (1978); HCSC Laundry v. United States, 450 U.S. 1 (1981).

³ IRS Private Letter Ruling 9822004 (Great Plains Health Alliance) (Tax Ct. Dkt. 9998-98 (May 29, 1998).

⁴ Kristen Hallam, IRS Targets Utah HMO, Modern Healthcare (Dec. 21-28, 1998)

⁵ See Redlands Surgical Services v. Commissioner of Internal Revenue Service, U.S. Tax Court Dkt. No. 11025-97 (filed Oct. 17, 1997); 113 T.C. No. 3 (July 19, 1999).

⁶ Barbara Yuill, IRS Official Identifies Key Factors in Whole Hospital Joint Venture Ruling, Health Law Reporter, Vol. 7, No. 30 (July 23, 1998) at 1177.

⁷ Internal Revenue Code Section 4958.

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