Joint Venture Surgicenter Won’t Jeopardize Exemption

Joint Venture Surgicenter Won’t Jeopardize Exemption —
As Long As the Hospital Is in Control

Action Kit

June 2001

Can a tax-exempt hospital or health system participate in a joint venture surgicenter with doctors on its medical staff without losing its tax-exempt status? According to a recent IRS ruling, the answer is yes, as long as the hospital is clearly in control of the venture.

The ruling in question, Private Letter Ruling 200118054, released by the IRS on May 4, 2001, provides helpful guidance on how to structure a joint venture in a way that will not only protect the hospital's tax exemption, but also assure that the hospital's share of the revenue from the joint venture is not subject to tax when distributed.

The joint venture in question was a limited liability company ("LLC") formed by a tax- exempt health system and some physicians on its medical staff. The health system initially owned 70% of the membership interests in the LLC, but planned to reduce its share to 51% as more doctors bought in. The LLC's operating agreement (its equivalent of bylaws) stated that its purpose is to lease and/or own and operate an ambulatory surgery center in furtherance of the tax-exempt and public charity purposes of the health system by promoting health for a broad cross section of its community and that this duty overrides any duty to operate the joint venture for the financial benefit of the members. Charity care would also be provided by the surgicenter.

The LLC was structured so that each member has a vote equal to the member's percentage interest in profits and losses at the time of the vote. This meant that the health system would always control membership votes with its 51% share. The following matters required the approval of a majority vote of the members:

(A) annual operating budget and capital budget;

(B) purchase of assets not included in the annual budgets in excess of $50,000 for any one item or $100,000 in the aggregate in any fiscal year;

(C) lease of assets as lessor not included in the annual budgets, with payments totaling in excess of $50,000 for any one item or $100,000 in the aggregate in any fiscal year;

(D) equipment leases as lessee not included in the annual budgets, with payments totaling in excess of $50,000 for any one item or $100,000 in the aggregate in any fiscal year;

(E) contracts with payments totaling in excess of $50,000 for any one item or $100,000 in the aggregate in any fiscal year;

(F) distribution of cash in an amount less than 90 percent of net income if accumulation of cash is required to allow the health system to further its tax-exempt and public charity purposes;

(G) distribution of cash in an amount greater than 90 percent of net income;

(H) approval or disapproval of recommendations from the board of directors;

(I) borrowing of money not included in the annual budgets in excess of$50,000 in total outstanding debt;

(J) pledging or mortgaging of assets;

(K) distribution of assets other than cash;

(L) removal of a member for cause;

(M) approval of the transfer of a member interest not specifically authorized by the operating agreement;

(N) engaging in a business unrelated to the ambulatory surgery center business;

(O) approval of the amount of fees to be paid to the directors.

The following matters required the approval of the health system and a 75% vote of the physician members:

(P) dissolution pursuant to approval of the members;

(Q) amendment of the operating agreement;

(R) amendment of the articles of organization if the amendment would change any provision of the operating agreement;

(S) approval of any management or service agreement with the health system.

Interestingly, a majority of the board of directors of the LLC, which was responsible for its day-to-day operations, was composed of physicians. The health system appointed two directors while the physicians elected four. However, the operating agreement was written so that each health system director had three votes on every matter that came before the board, which meant that the health system had "voting control" of the board even though its representatives were in the numerical minority.

In the end, the IRS ruled that the formation and operation of the joint venture would further the health system's

tax-exempt purposes and that any distribution from the surgicenter would not constitute unrelated business income. What mattered most to the IRS was the fact that the health system was guaranteed effective control of the LLC's governing board and decision-making structure. This meant that the health system could ensure that the surgicenter would primarily operate in a manner consistent with the health system's charitable mission.

This ruling stands in contrast to the result in the Redlands Surgical Services case where the tax court (recently upheld by the Ninth Circuit Court of Appeals) denied an application for exemption from a hospital affiliate that participated in a joint venture surgicenter but did not have effective control over its governance and operations. [See the July/August 1999 issue of ACTION KIT for Hospital Trustees for a discussion of the Redlands opinion.]

This ruling, like any private letter ruling, can be relied upon only by the entity that requested it. But it provides a helpful road map for hospitals that may wish (or be forced) to deal with physicians seeking to compete with them in the outpatient surgery market.

The IRS is not the only regulatory agency that must be dealt with when setting up a joint venture surgicenter. The Office of Inspector General published a safe harbor regulation in November 1999 which should also be adhered to in order to maximize legal protection. And the idea of hospital control may not sit well with potential physician partners (although it may provide comfort to potential lenders.)

Still, if the hospital has made a choice to participate in a joint venture surgicenter with its physicians, making sure that its tax-exempt status is protected is critical, as is protecting the tax exemption for its share of the surgicenter's revenue. Since the hospital will already lose a substantial portion of its surgical revenue to the joint venture, (and perhaps even more to a competing totally physician-owned surgi-center) protecting what is left from federal taxes becomes all the more important in these times of shrinking margins and fiscal chaos.