IRS Revenue Ruling
1998-15

Code Secs. 501, 170

<<FULL TEXT>>

26 CFR 1.501(c)(3)-1: Organizations organized and operated for religious
charitable scientific testing for public safety literary or educational
purposes or for the prevention of cruelty to children or animals.
(Also sections 170 and 509.)

Tax consequences of participation by hospitals described in section
501(c)(3) of the Code in joint ventures with for-profit entities. This
ruling provides examples illustrating whether nonprofit hospitals that
participate in joint ventures with for-profit entities continue to qualify
for exemption as organizations described in section 501(c)(3) of the Code.


REV. RUL. 98-15

ISSUE

Whether, under the facts described below, an organization that operates
an acute care hospital continues to qualify for exemption from federal
income tax as an organization described in section 501(c)(3) of the
Internal Revenue Code when it forms a limited liability company (LLC) with
a for-profit corporation and then contributes its hospital and all of its
other operating assets to the LLC, which then operates the hospital.


FACTS

SITUATION 1

A is a nonprofit corporation that owns and operates an acute care
hospital. A has been recognized as exempt from federal income tax under
section 501(a) as an organization described in section 501(c)(3) and as
other than a private foundation as defined in section 509(a) because it is
described in section 170(b)(1)(A)(iii). B is a for-profit corporation that
owns and operates a number of hospitals.

A concludes that it could better serve its community if it obtained
additional funding. B is interested in providing financing for A's
hospital, provided it earns a reasonable rate of return. A and B form a
limited liability company, C. A contributes all of its operating assets,
including its hospital to C. B also contributes assets to C. In return, A
and B receive ownership interests in C proportional and equal in value to
their respective contributions.

C's Articles of Organization and Operating Agreement ("governing
documents") provide that C is to be managed by a governing board
consisting of three individuals chosen by A and two individuals chosen by
B. A intends to appoint community leaders who have experience with
hospital matters, but who are not on the hospital staff and do not
otherwise engage in business transactions with the hospital.

The governing documents further provide that they may only be amended
with the approval of both owners and that a majority of three board
members must approve certain major decisions relating to C's operation,
including decisions relating to any of the following topics:

A. C's annual capital and operating budgets;

B. Distributions of C's earnings;

C. Selection of key executives;

D. Acquisition or disposition of health care facilities;

E. Contracts in excess of $x per year;

F. Changes to the types of services offered by the hospital; and

G. Renewal or termination of management agreements.


The governing documents require that C operate any hospital it owns in
a manner that furthers charitable purposes by promoting health for a broad
cross section of its community. The governing documents explicitly provide
that the duty of the members of the governing board to operate C in a
manner that furthers charitable purposes by promoting health for a broad
cross section of the community overrides any duty they may have to operate
C for the financial benefit of its owners. Accordingly, in the event of a
conflict between operation in accordance with the community benefit
standard and any duty to maximize profits, the members of the governing
board are to satisfy the community benefit standard without regard to the
consequences for maximizing profitability.

The governing documents further provide that all returns of capital and
distributions of earnings made to owners of C shall be proportional to
their ownership interests in C. The terms of the governing documents are
legal, binding, and enforceable under applicable state law.

C enters into a management agreement with a management company that is
unrelated to A or B to provide day-to-day management services to C. The
management agreement is for a five-year period, and the agreement is
renewable for additional five-year periods by mutual consent. The
management company will be paid a management fee for its services based on
C's gross revenues. The terms and conditions of the management agreement,
including the fee structure and the contract term, are reasonable and
comparable to what other management firms receive for similar services at
similarly situated hospitals. C may terminate the agreement for cause.

None of the officers, directors, or key employees of A who were
involved in making the decision to form C were promised employment or any
other inducement by C or B and their related entities if the transaction
were approved. None of A's officers, directors, or key employees have any
interest, including any interest through attribution determined in
accordance with the principles of section 318, in B or any of its related
entities.

Pursuant to section 301.7701-3(b) of the Procedure and Administrative
Regulations, C will be treated as a partnership for federal income tax
purposes.

A intends to use any distributions it receives from C to fund grants to
support activities that promote the health of A's community and to help
the indigent obtain health care. Substantially all of A's grantmaking will
be funded by distributions from C. A's projected grantmaking program and
its participation as an owner of C will constitute A's only activities.


SITUATION 2

D is a nonprofit corporation that owns and operates an acute care
hospital. D has been recognized as exempt from federal income tax under
section 501(a) as an organization described in section 501(c)(3) and as
other than a private foundation as defined in section 509(a) because it is
described in section 170(b)(1)(A)(iii). E is a for-profit hospital
corporation that owns and operates a number of hospitals and provides
management services to several hospitals that it does not own.

D concludes that it could better serve its community if it obtained
additional funding. E is interested in providing financing for D's
hospital, provided it earns a reasonable rate of return. D and E form a
limited liability company, F. D contributes all of its operating assets,
including its hospital to F. E also contributes assets to F. In return, D
and E receive ownership interests proportional and equal in value to their
respective contributions.

F's Articles of Organization and Operating Agreement ("governing
documents") provide that F is to be managed by a governing board
consisting of three individuals chosen by D and three individuals chosen
by E. D intends to appoint community leaders who have experience with
hospital matters, but who are not on the hospital staff and do not
otherwise engage in business transactions with the hospital.

The governing documents further provide that they may only be amended
with the approval of both owners and that a majority of board members must
approve certain major decisions relating to F's operation, including
decisions relating to any of the following topics:

A. F's annual capital and operating budgets;

B. Distributions of F's earnings over a required minimum level of
distributions set forth in the Operating Agreement;

C. Unusually large contracts; and

D. Selection of key executives.


F's governing documents provide that F's purpose is to construct,
develop, own, manage, operate, and take other action in connection with
operating the health care facilities it owns and engage in other health
care-related activities. The governing documents further provide that all
returns of capital and distributions of earnings made to owners of F shall
be proportional to their ownership interests in F.

F enters into a management agreement with a wholly-owned subsidiary of
E to provide day-to-day management services to F. The management agreement
is for a five-year period, and the agreement is renewable for additional
five-year periods at the discretion of E's subsidiary. F may terminate the
agreement only for cause. E's subsidiary will be paid a management fee for
its services based on gross revenues. The terms and conditions of the
management agreement, including the fee structure and the contract term
other than the renewal terms, are reasonable and comparable to what other
management firms receive for similar services at similarly situated
hospitals.

As part of the agreement to form F, D agrees to approve the selection
of two individuals to serve as F's chief executive officer and chief
financial officer. These individuals have previously worked for E in
hospital management and have business expertise. They will work with the
management company to oversee F's day-to-day management. Their
compensation is comparable to what comparable executives are paid at
similarly situated hospitals.

Pursuant to section 301.7701-3(b), F will be treated as a partnership
for federal tax income purposes.

D intends to use any distributions it receives from F to fund grants to
support activities that promote the health of D's community and to help
the indigent obtain health care. Substantially all of D's grantmaking will
be funded by distributions from F. D's projected grantmaking program and
its participation as an owner of F will constitute D's only activities.


LAW

Section 501(c)(3) provides, in part, for the exemption from federal
income tax of corporations organized and operated exclusively for
charitable, scientific, or educational purposes, provided no part of the
organization's net earnings inures to the benefit of any private
shareholder or individual.

Section 1.501(c)(3)-1(c)(1) of the Income Tax Regulations provides that
an organization will be regarded as operated exclusively for one or more
exempt purposes only if it engages primarily in activities which
accomplish one or more of such exempt purposes specified in section
501(c)(3). An organization will not be so regarded if more than an
insubstantial part of its activities is not in furtherance of an exempt
purpose. In Better Business Bureau of Washington, D.C. v. United States,
326 U.S. 279, 283 (1945), the Court stated that "the presence of a single
. . . [non-exempt] purpose, if substantial in nature, will destroy the
exemption regardless of the number or importance of truly . . . [exempt]
purposes."

Section 1.501(c)(3)-1(d)(1)(ii) provides that an organization is not
organized or operated exclusively for exempt purposes unless it serves a
public rather than a private interest. It further states that "to meet the
requirement of this subdivision, it is necessary for an organization to
establish that it is not organized and operated for the benefit of private
interests . . .."

Section 1.501(c)(3)-1(d)(2) provides that the term "charitable" is used
in section 501(c)(3) in its generally accepted legal sense. The promotion
of health has long been recognized as a charitable purpose. See
Restatement (Second) of Trusts, sections 368, 372 (1959); 4A Austin W.
Scott and William F. Fratcher, The Law of Trusts sections 368, 372 (4th
ed. 1989). However, not every activity that promotes health supports tax
exemption under section 501(c)(3). For example, selling prescription
pharmaceuticals certainly promotes health, but pharmacies cannot qualify
for recognition of exemption under section 501(c)(3) on that basis alone.
Federation Pharmacy Services, Inc. v. Commissioner, 72 T.C. 687 (1979),
aff'd, 625 F.2d 804 (8th Cir. 1980) ("Federation Pharmacy"). Furthermore,
"an institution for the promotion of health is not a charitable
institution if it is privately owned and is run for the profit of the
owners." 4A Austin W. Scott and William F. Fratcher, The Law of Trusts
section 372.1 (4th ed. 1989). See also Restatement (Second) of Trusts,
section 376 (1959). This principle applies to hospitals and other health
care organizations. As the Tax Court stated, "[w]hile the diagnosis and
cure of disease are indeed purposes that may furnish the foundation for
characterizing the activity as 'charitable,' something more is required."
Sonora Community Hospital v. Commissioner, 46 T.C. 519, 525-526 (1966),
aff'd 397 F.2d 814 (9th Cir. 1968) ("Sonora"). See also Sound Health
Association v. Commissioner, 71 T.C. 158 (1978), acq. 1981-2 C.B. 2
("Sound Health"); Geisinger Health Plan v. Commissioner, 985 F.2d 1210
(3rd Cir., 1993), rev'g 62 T.C.M. 1656 (1991) ("Geisinger").

<<END RULING>>


In evaluating whether a nonprofit hospital qualifies as an organization
described in section 501(c)(3), Rev. Rul. 69-545, 1969-2 C.B. 117,
compares two hospitals. The first hospital discussed is controlled by a
board of trustees composed of independent civic leaders. In addition, the
hospital maintains an open medical staff, with privileges available to all
qualified physicians; it operates a full-time emergency room open to all
regardless of ability to pay; and it otherwise admits all patients able to
pay (either themselves, or through third party payers such as private
health insurance or government programs such as Medicare). In contrast,
the second hospital is controlled by physicians who have a substantial
economic interest in the hospital. This hospital restricts the number of
physicians admitted to the medical staff, enters into favorable rental
agreements with the individuals who control the hospital, and limits
emergency room and hospital admission substantially to the patients of the
physicians who control the hospital. Rev. Rul. 69-545 notes that in
considering whether a nonprofit hospital is operated to serve a private
benefit, the Service will weigh all the relevant facts and circumstances
in each case, including the use and control of the hospital. The revenue
ruling concludes that the first hospital continues to qualify as an
organization described in section 501(c)(3) and the second hospital does
not because it is operated for the private benefit of the physicians who
control the hospital.

Section 509(a) provides that the term "private foundation" means a
domestic or foreign organization described in section 501(c)(3) other than
an organization described in section 509(a)(1), (2), (3), or (4). The
organizations described in section 509(a)(1) include those described in
section 170(b)(1)(A)(iii). An organization is described in section
170(b)(1)(A)(iii) if its principal purpose is to provide medical or
hospital care.

Section 512(c) provides that an exempt organization that is a member of
a partnership conducting an unrelated trade or business with respect to
the exempt organization must include its share of the partnership income
and deductions attributable to that business (subject to the exceptions,
additions, and limitations in section 512(b)) in computing its unrelated
business income. See also H.R. No. 2319, 81st Cong., 2d Sess. 36, 111-112
(1950); S. Rep. No. 2375, 81st Cong., 2d Sess. 26, 109-110 (1950); section
1.512(c)-1.

In Butler v. Commissioner, 36 T.C. 1097 (1961), acq. 1962-2 C.B. 4
("Butler"), the court examined the relationship between a partner and a
partnership for purposes of determining whether the partner was entitled
to a business bad debt deduction for a loan he had made to the partnership
that it could not repay. In holding that the partner was entitled to the
bad debt deduction, the court noted that "[b]y reason of being a partner
in a business, petitioner was individually engaged in business." Butler,
36 T.C. at 1106 citing Dwight A. Ward v. Commissioner, 20 T.C. 332 (1953),
aff'd 224 F.2d 547 (9th Cir. 1955).

In Plumstead Theatre Society, Inc. v. Commissioner, 74 T.C. 1324
(1980), aff'd, 675 F.2d 244 (9th Cir. 1982) ("Plumstead"), the Tax Court
held that a charitable organization's participation as a general partner
in a limited partnership did not jeopardize its exempt status. The
organization co-produced a play as one of its charitable activities. Prior
to the opening of the play, the organization encountered financial
difficulties in raising its share of costs. In order to meet its funding
obligations, the organization formed a limited partnership in which it
served as general partner, and two individuals and a for-profit
corporation were the limited partners. One of the significant factors
supporting the Tax Court's holding was its finding that the limited
partners had no control over the organization's operations.

In Broadway Theatre League of Lynchburg, Virginia, Inc. v. U.S., 293 F.
Supp. 346 (W.D. Va. 1968) ("Broadway Theatre League"), the court held that
an organization that promoted an interest in theatrical arts did not
jeopardize its exempt status when it hired a booking organization to
arrange for a series of theatrical performances, promote the series and
sell season tickets to the series because the contract was for a
reasonable term and provided for reasonable compensation and the
organization retained ultimate authority over the activities being
managed.

In Housing Pioneers v. Commissioner, 65 T.C.M. (CCH) 2191 (1993),
aff'd, 49 F.3d 1395 (9th Cir. 1995), amended 58 F.3d 401 (9th Cir. 1995)
("Housing Pioneers"), the Tax Court concluded that an organization did not
qualify as a section 501(c)(3) organization because its activities
performed as co-general partner in for-profit limited partnerships
substantially furthered a non-exempt purpose, and serving that purpose
caused the organization to serve private interests. The organization
entered into partnerships as a one percent co-general partner of existing
limited partnerships for the purpose of splitting the tax benefits with
the for-profit partners. Under the management agreement, the
organization's authority as co-general partner was narrowly circumscribed.
It had no management responsibilities and could describe only a vague
charitable function of surveying tenant needs.

In est of Hawaii v. Commissioner, 71 T.C. 1067 (1979), aff'd in
unpublished opinion 647 F.2d 170 (9th Cir. 1981) ("est of Hawaii"),
several for-profit est organizations exerted significant indirect control
over est of Hawaii, a non-profit entity, through contractual arrangements.
The Tax Court concluded that the for-profits were able to use the
non-profit as an "instrument" to further their for-profit purposes.
Neither the fact that the for-profits lacked structural control over the
organization nor the fact that amounts paid to the for-profit
organizations under the contracts were reasonable affected the court's
conclusion. Consequently, est of Hawaii did not qualify as an organization
described in section 501(c)(3).
In Harding Hospital, Inc. v. United States, 505 F.2d 1068 (6th Cir.
1974) ("Harding"), a non-profit hospital with an independent board of
directors executed a contract with a medical partnership composed of seven
physicians. The contract gave the physicians control over care of the
hospital's patients and the stream of income generated by the patients
while also guaranteeing the physicians thousands of dollars in payment for
various supervisory activities. The court held that the benefits derived
from the contract constituted sufficient private benefit to preclude
exemption.


ANALYSIS

For federal income tax purposes, the activities of a partnership are
often considered to be the activities of the partners. See, e.g., Butler.
Aggregate treatment is also consistent with the treatment of partnerships
for purpose of the unrelated business income tax under section 512(c). See
H.R. No. 2319, 81st Cong., 2d Sess. 36, 110-112 (1950); S. Rep. No. 2375,
81st Cong., 2d Sess. 26, 109-110 (1950); section 1.512(c)-1. In light of
the aggregate principle discussed in Butler and reflected in section
512(c), the aggregate approach also applies for purposes of the
operational test set forth in section 1.501(c)(3)-1(c). Thus, the
activities of an LLC treated as a partnership for federal income tax
purposes are considered to be the activities of a nonprofit organization
that is an owner of the LLC when evaluating whether the nonprofit
organization is operated exclusively for exempt purposes within the
meaning of section 501(c)(3).

A section 501(c)(3) organization may form and participate in a
partnership, including an LLC treated as a partnership for federal income
tax purposes, and meet the operational test if participation in the
partnership furthers a charitable purpose, and the partnership arrangement
permits the exempt organization to act exclusively in furtherance of its
exempt purpose and only incidentally for the benefit of the for-profit
partners. See Plumstead and Housing Pioneers. Similarly, a section
501(c)(3) organization may enter into a management contract with a private
party giving that party authority to conduct activities on behalf of the
organization and direct the use of the organization's assets provided that
the organization retains ultimate authority over the assets and activities
being managed and the terms and conditions of the contract are reasonable,
including reasonable compensation and a reasonable term. See Broadway
Theatre League. However, if a private party is allowed to control or use
the non-profit organization's activities or assets for the benefit of the
private party, and the benefit is not incidental to the accomplishment of
exempt purposes, the organization will fail to he organized and operated
exclusively for exempt purposes. See est of Hawaii; Harding; section
1.501(c)(3)-1(c)(1); and section 1.501(c)(3)-1(d)(1)(ii).


SITUATION 1

After A and B form C, and A contributes all of its operating assets to
C, A's activities will consist of the health care services it provides
through C and any grantmaking activities it can conduct using income
distributed by C. A will receive an interest in C equal in value to the
assets it contributes to C, and A's and B's returns from C will be
proportional to their respective investments in C. The governing documents
of C commit C to providing health care services for the benefit of the
community as a whole and to give charitable purposes priority over
maximizing profits for C's owners. Furthermore, through A's appointment of
members of the community familiar with the hospital to C's board, the
board's structure, which gives A's appointees voting control, and the
specifically enumerated powers of the board over changes in activities,
disposition of assets, and renewal of the management agreement, A can
ensure that the assets it owns through C and the activities it conducts
through C are used primarily to further exempt purposes. Thus, A can
ensure that the benefit to B and other private parties, like the
management company, will be incidental to the accomplishment of charitable
purposes. Additionally, the terms and conditions of the management
contract, including the terms for renewal and termination, are reasonable.
Finally, A's grants are intended to support education and research and
give resources to help provide health care to the indigent. All of these
facts and circumstances establish that, when A participates in forming C
and contributes all of its operating assets to C, and C operates in
accordance with its governing documents, A will be furthering charitable
purposes and continue to be operated exclusively for exempt purposes.

Because A's grantmaking activity will be contingent upon receiving
distributions from C, A's principal activity will continue to be the
provision of hospital care. As long as A's principal activity remains the
provision of hospital care, A will not be classified as a private
foundation in accordance with section 509(a)(1) as an organization
described in section 170(b)(1)(A)(iii).


SITUATION 2

When D and E form F, and D contributes its assets to F; D will be
engaged in activities that consist of the health care services it provides
through F and any grantmaking activities it can conduct using income
distributed by F. However, unlike A, D will not be engaging primarily in
activities that further an exempt purpose. "While the diagnosis and cure
of disease are indeed purposes that may furnish the foundation for
characterizing the activity as 'charitable,' something more is required."
Sonora, 46 T.C. at 525-526. See also Federation Pharmacy; Sound Health;
and Geisinger. In the absence of a binding obligation in F's governing
documents for F to serve charitable purposes or otherwise provide its
services to the community as a whole, F will be able to deny care to
segments of the community, such as the indigent. Because D will share
control of F with E, D will not be able to initiate programs within F to
serve new health needs within the community without the agreement of at
least one governing board member appointed by E. As a business enterprise,
E will not necessarily give priority to the health needs of the community
over the consequences for F's profits. The primary source of information
for board members appointed by D will be the chief executives, who have a
prior relationship with E and the management company, which is a
subsidiary of E. The management company itself will have broad discretion
over F's activities and assets that may not always be under the board's
supervision. For example, the management company is permitted to enter
into all but "unusually large" contracts without board approval. The
management company may also unilaterally renew the management agreement.
Based on all these facts and circumstances, D cannot establish that the
activities it conducts through F further exempt purposes. "[I]n order for
an organization to qualify for exemption under section 501(c)(3) the
organization must 'establish' that it is neither organized nor operated
for the 'benefit of private interests.'" Federation Pharmacy, 625 F.2d at
809. Consequently, the benefit to E resulting from the activities D
conducts through F will not be incidental to the furtherance of an exempt
purpose. Thus, D will fail the operational test when it forms F,
contributes its operating assets to F, and then serves as an owner of F.


HOLDING

A will continue to qualify as an organization described in section
501(c)(3) when it forms C and contributes all of its operating assets to C
because A has established that A will be operating exclusively for a
charitable purpose and only incidentally for the purpose of benefiting the
private interests of B. Furthermore, A's principal activity will continue
to be the provision of hospital care when C begins operations. Thus, A
will be an organization described in section 170(b)(1)(A)(iii) and thus,
will not be classified as a private foundation in accordance with section
509(a)(1), as long as hospital care remains its principal activity.

D will violate the requirements to be an organization described in
section 501(c)(3) when it forms F and contributes all of its operating
assets to F because D has failed to establish that it will be operated
exclusively for exempt purposes.


DRAFTING INFORMATION

The principal author of this revenue ruling is Judith E. Kindell of the
Exempt Organizations Division. For further information regarding this
revenue ruling contact Judith E. Kindell on (202) 622-6494 (not a
toll-free call).

<<END RULING>>

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