Tax-exempt health care systems: Protect exempt status when entering joint ventures

As health care systems seek revenue diversification and private equity groups continue to invest in health care, tax-exempt health care organizations must be mindful of the possible pitfalls in embarking on joint venture arrangements with for-profit entities.

Tax-exempt hospitals and providers should look for ways to preserve their tax-exempt status and be aware of unrelated business income issues that may arise with these arrangements. To preserve its status, an exempt organization must be organized and operated exclusively for qualified tax-exempt purposes. When an exempt organization invests in a joint venture partnership, the activities of the partnership become those of the organization. If the overall activities from the partnership are not mission related and account for a substantial portion of the organization’s activities, the organization is no longer considered operated exclusively for tax-exempt purposes and is at risk of losing its exempt status. 

Maintaining exempt status

With this in mind, before a joint venture is finalized, a health care organization must assess whether the activities of the joint venture will be related to the organization’s exempt purpose. 

To determine this, the organization must first establish whether it will have sufficient control over the partnership to ensure that its activities primarily further charitable purposes. If the tax-exempt partner has a majority voting and ownership interest in the partnership, it will typically retain control of the joint venture. If the exempt organization’s ownership interest is not more than 50%, it must retain sufficient control over the governance and management of the partnership to ensure that the joint venture will further the organization’s exempt purposes. For example, in Revenue Ruling 2004-51, the IRS determined that activities conducted through a 50-50 partnership between an exempt organization and a for-profit partner were related to the exempt organization’s exempt purpose, where the tax-exempt partner alone could approve the exempt purpose activity of the partnership and compel the partnership to operate in furtherance of its mission.

To meet the control test, the organization should determine whether the underlying activities of the joint venture are mission related. Note that mission-related activities that were historically conducted by the health care organization directly, but were subsequently transferred to the joint venture, may cease to be treated as related activities if the organization does not control the joint venture.

For hospitals, mission-related work typically involves direct patient contact. When a joint venture arrangement outsources patient care and provides only management services, the management activity typically falls into the category of unrelated business income and may jeopardize the exempt status of a health care organization.

Private benefit, management contracts and partnership agreements

Tax-exempt health care organizations must ensure that they serve a public rather than private interest. Accordingly, organizations participating in joint ventures need to evaluate whether a partnership arrangement confers an impermissible private benefit to for-profit partners, which could jeopardize the organization’s exempt status. Organizations must ensure that the terms of the arrangement are commercially reasonable, are conducted at arm’s length and do not favor the for-profit partner by having the exempt partner absorb more entrepreneurial and operating risk than the for-profit partner.

One common structure among tax-exempt health systems that may give rise to private benefit concerns is when a joint venture enters into a management contract with an affiliate of the for-profit joint venture partner. In this scenario, the tax-exempt partner must be certain that the management agreement does not result in the delegation of control over the partnership’s operations to the management company, and that the agreement is commercially reasonable and does not confer excessive benefit or compensation to the for-profit entities. The management agreement should tie back to the charitable purposes provisions in the joint venture operating agreement.

The tax-exempt organization can demonstrate control by acting as the general partner, managing member, or by appointing the majority of the governing board. Alternatively, it can have unilateral control over defined activities of the joint venture, which includes reserved powers for governing charity care policies and services for underserved populations, participation in Medicaid and other means-tested programs, and management of patient care.

In addition, the partnership agreement should ensure that the joint venture furthers the purposes of Internal Revenue Code section 501(c)(3) and will not jeopardize or adversely affect the organization’s section 501(c)(3) status, or incur a significant amount of unrelated business income tax. For hospitals, the partnership agreement should include language explicitly required for the organization to maintain exempt status. For example, the agreement should require a community health needs assessment; a financial assistance policy; a limit on the amounts charged to individuals eligible for financial assistance and a reasonable effort to determine financial assistance eligibility before engaging in extraordinary collection actions; and the promotion of community benefit. Revenue from activities unrelated to an organization’s exempt status is considered unrelated business income and subject to income tax.

For more information, work with your tax advisor to understand the implications of a joint venture arrangement.