IRS Ruling Is Cause For Tax-Exempt Provider ConcernJuly 20, 2016 | |
A recent ruling by the Internal Revenue Service has raised concerns about the applicability of tax-exempt status to accountable care organizations. The IRS has taken action which will cause tax-exempt organizations to pause and carefully examine their participation in ACOs or other provider networks, particularly when such an ACO or network does not participate in the Medicare Shared Savings Program (MSSP). The ruling serves to highlight a practical concern that many tax-exempt provider organizations have had with respect to their participation in ACOs or other clinically integrated networks that include diverse not-for-profit and for-profit providers.
Section 3022 of the ACA amended Title XVIII of the Social Security Act (42 U.S.C. 1395 et seq.) by adding a new § 1899, which directed the secretary of the U.S. Department of Health and Human Services to establish a MSSP. The MSSP was one of the initial transitionary programs designed to incentivize providers to start moving away from volume to value. The MSSP was intended to encourage physicians, hospitals and other health care providers to form ACOs to assume accountability and coordinate their services for a defined patient population of Medicare beneficiaries attributed to them based on the patients’ utilization of primary care services.
In a coordinated effort unlike any other in the history of health care delivery in the United States, multiple federal agencies jointly and simultaneously announced regulatory relief designed to further incentivize providers to establish ACOs and participate in the MSSP. Specifically, the Centers for Medicare and Medicaid Services and the HHS Office of Inspector General jointly issued waivers of certain federal fraud and abuse laws, including the physician self-referral law and the anti-kickback statute, as well as certain provisions of the civil monetary penalty law, in connection with the MSSP.
In addition, the Federal Trade Commission and the U.S. Department of Justice jointly issued a “Statement of Antitrust Enforcement Regarding Accountable Care Organizations Participating in the Medicare Shared Savings Program” (antitrust policy statement). Finally, the IRS issued a notice summarizing how they expect existing IRS guidance may apply to § 501(c)(3) tax-exempt organizations (charitable organizations), such as charitable hospitals, participating in the MSSP through ACOs.
Exemption under Code § 501(c)(3)
Section 501(c)(3) of the Internal Revenue Code (code) 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 a private shareholder or individual. Treasury Regulation §1.501(c)(3)-1(c)(1) clarifies that an organization will be regarded as operated exclusively for one or more exempt purposes only if it engages primarily in activities that accomplish one or more of such exempt purposes specified in §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.
Treasury Regulation §1.501(c)(3)-1(c)(2) states that an organization is not operated exclusively for charitable purposes if its net earnings inure in whole or in part to the benefit of private shareholders or individuals, a concept commonly referred to as the “private inurement” doctrine. The term “net earnings” has been interpreted by applicable courts as referring to an “advantage, profit, fruit, privilege, gain [or] interest” derived from the organization. Treasury Regulation §1.501(a)-1(c) defines “private shareholder or individual” as referring to persons having a personal and private interest in the activities of the organization. Treasury Regulation §1.501(c)(3)-1(d)(1)(ii) states that an organization is not organized exclusively for any of the purposes specified in § 501(c)(3) unless it serves public, rather than private interests. The burden is on the organization applying for tax exemption under §501(c)(3) to establish that it is not organized or operated for the benefit of private interests.
Treasury Regulation §1.501(c)(3)-1(d)(2) provides that the term “charitable” is used in § 501(c)(3) in its generally accepted legal sense and includes such purposes as relief of the poor and distressed or of the underprivileged; advancement of religion; advancement of education or science; and lessening of the burdens of government. A determination of whether an organization is lessening the burdens of government requires consideration of whether the organization’s activities are ones that a government unit considers to be its burden, and whether such activities actually lessen that burden, based on all the facts and circumstances.
IRS Safe Harbor — “So Far, So Good”
Hospitals and other health care organizations recognized as organizations described in §501(c)(3) of the code are obvious candidates for participation in an ACO or other type of clinically integrated network of providers. As such, on Oct. 20, 2011, the IRS released notice 2011-20 in an effort to clarify its position on the tax-exempt status of entities planning to participate in the MSSP through an ACO, as well as to solicit comments concerning (1) whether guidance relating to the code provisions governing tax-exempt organizations is sufficient for those tax-exempt organizations planning to participate in the MSSP through an ACO and, if not, what additional guidance was needed, and (2) whether guidance was necessary regarding the tax implications for tax-exempt organizations participating in activities unrelated to the MSSP, including shared savings arrangements with commercial health insurance payers, through ACOs.
In this notice, the IRS acknowledged that tax-exempt organizations typically may be participating in the MSSP through an ACO along with private parties, including some that might be considered insiders with respect to those tax-exempt organizations. Touching upon the private inurement doctrine, the IRS went on to explain that in order to avoid adverse tax consequences, the tax-exempt organization must ensure that its participation in the MSSP through an ACO is structured so as not to result in its net earnings inuring to the benefit of its insiders or in its being operated for the benefit of private parties participating in that ACO.
Interestingly, the notice proceeded to provide something akin to a safe harbor, designed to reflect the IRS’ acknowledgement of CMS’s oversight of the MSSP; in other words, the fact that the MSSP was so clearly within the purview of CMS obviated the IRS’s need to determine whether prohibited inurement or impermissible private benefit had occurred on a case-by-case basis if certain enumerated conditions were met generally relating to the tax-exempt organization’s dealings with the ACO and the ACO’s continued relationship with CMS. Those conditions were as follows:
- The terms of the tax-exempt organization’s participation in the MSSP through the ACO (including its share of MSSP payments or losses and expenses) are set forth in advance in a written agreement negotiated at arm’s length.
- CMS has accepted the ACO into, and has not terminated the ACO from, the MSSP.
- The tax-exempt organization’s share of economic benefits derived from the ACO (including its share of MSSP payments) is proportional to the benefits or contributions the tax-exempt organization provides to the ACO. If the tax-exempt organization receives an ownership interest in the ACO, the ownership interest received is proportional and equal in value to its capital contributions to the ACO and all ACO returns of capital, allocations and distributions are made in proportion to ownership interests.
- The tax-exempt organization’s share of the ACO’s losses (including its share of MSSP losses) does not exceed the share of ACO economic benefits to which the tax-exempt organization is entitled.
- All contracts and transactions entered into by the tax-exempt organization with the ACO and the ACO’s participants, and by the ACO with the ACO’s participants and any other parties, are at fair market value.
Private Letter Ruling – “Not So Fast”
Though potentially foreshadowed throughout notice 2011-20, the IRS did not go as far as to deny tax-exempt status to an ACO that was not participating in the MSSP (i.e., a “commercial ACO”) until earlier this year. The IRS pointed out in the notice that “the ‘promotion of health has long been recognized as a charitable purpose,’” (citing Rev. Rul. 98-15, 1998-1 C.B. 718), but “not every activity that promotes health supports tax exemption under §501(c)(3).” The notice also cited revenue ruling 98-15, pointing out that, “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.”
The final adverse determination revoking this particular organization’s tax-exempt status under §501(c)(3) came in April 2016, in the form of private letter ruling 201615022 (April 8, 2016). The IRS’s primary findings were: (1) the organization did not engage primarily in activities accomplishing one or more code §501(c)(3)’s exempt purposes; (2) more than an insubstantial part of the organization’s activities furthered nonexempt purposes; and (3) the organization was operated for the benefit of private rather than public interests.
Having established that not every activity that promotes health supports tax exemption, the IRS went on to examine whether this ACO could be viewed as “lessening the burdens of government.” In order to do so, the IRS explained that there must be “an objective manifestation that the government considers the activities to be its burden.” It found that while ACOs participating in the MSSP will generally be found to further the charitable purpose of lessening the burdens of government within the meaning of Treasury Regulation §1.501(c)(3)-1(d)(2), in contrast, the law does not provide an objective manifestation that the government considers non-MSSP related ACO activities to be its burden, even if those activities serve to further the Affordable Care Act’s triple aim goals of improving patient experience, improving population health and reducing per capita cost.
In effect, because there is no government oversight of this ACO’s activities similar to that of an ACO participating in the MSSP and because this ACO is not engaged primarily in assisting the Medicare or Medicaid population, which could further the charitable purpose of relieving the poor and distressed, tax-exemption is not appropriate in this instance.
The IRS went on to further bolster its determination, pointing out that one of this ACO’s substantial activities, the negotiation of payer agreements on behalf of this ACO’s health care provider participants, is not a charitable activity. After pointing out that “[the] presence of a single substantial nonexempt purpose destroys the exemption regardless of the number or important of the exempt purposes,” the IRS held that the negotiation of payer agreements on behalf of health care providers would have precluded a finding of tax-exemption even if the ACO had been able to show that it did serve one or more charitable purposes.
Ancillary Tax Issues — “It Gets Worse?”
Both notice 2011-20 and PLR 201615022 also touch on one additional area of concern for ACOs, namely whether an ACO that is deemed tax-exempt because of its participation in the MSSP would be subject to unrelated business income tax (UBIT) pursuant to code §511 by virtue of its activities unrelated to the MSSP, such as entering into and operating under shared savings arrangements with other types of health insurance payers (e.g., private health insurers).
Code §512(a)(1) defines “unrelated business taxable income” as the gross income derived by any organization from any unrelated trade or business (as defined in code §513) regularly carried on by it less the deductions allowed, both computed with the modifications provided in code §512(b). Code §513(a) defines the term “unrelated trade or business” as any trade or business the conduct of which is not substantially related (aside from the need of the organization for income or funds or the use it makes of the profits derived) to the exercise or performance by the organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under code §501. To be substantially related, the activity “must contribute importantly to the accomplishment of [exempt] purposes.”
While the notice merely requested comments regarding how a tax-exempt organization’s participation in particular non-MSPP activities through an ACO further or are substantially related to an exempt purpose, the PLR’s denial of tax-exempt status to the subject ACO, partially on the basis of its substantial nonexempt purpose, should send a clear signal to ACOs that such activities may trigger UBIT. Furthermore, if an existing tax-exempt organization is a partner (or member, in the case of an LLC) of an ACO treated as a partnership or disregarded entity for federal income tax purposes, the ACO’s activities will be attributed to the tax-exempt organization both for purposes of determining whether the organization operates exclusively for exempt purposes and whether it is engaged in an unrelated trade or business. This presents a very real concern for any tax-exempt partner or member of such an ACO.
The primary lesson learned from this recent ruling is that even if a tax-exempt provider is engaged in activities which are intended to improve the quality of health of a population, such activities must also be substantially related to a specifically identified charitable purpose, and must not, simultaneously, benefit private interests. Tax-exempt ACOs must engage primarily in activities accomplishing one or more of code §501(c)(3)’s exempt purposes, any activities furthering nonexempt purposes must be an insubstantial part of the organization’s activities and the organization must not be operated for the benefit of private rather than public interests.
 Internal Revenue Service Private Letter Ruling 201615002, April 8, 2016.
 Harding Hospital v. United States, 505 F.2d 1068, 1072 (6th Cir. 1964); Retired Teachers Legal Defense Fund v. Commissioner, 78 T.C. 280, 286 (1982).
 Treas. Reg. §1.513-1(d)(2).
 See, e.g., Rev. Rul. 2004-51; Rev. Rul. 98-15.
Reprinted with permission from Law360. All rights reserved.
This article was co-written with David Manko, Esq.