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Tax Exempt Status of Hospital Not Affected by Proposed Joint Venture. In
LTR 200304041, released November 1, 2002, the Service considered a proposed LLC joint
venture of the tax exempt hospital with cardiologist to operate a cardiac catheterization lab. The
full text of the letter ruling follows:
Release Date: NOVEMBER 01, 2002
Issue List: 501.03-11, 512.03-00, 513.00-00
Date: November 1, 2002
Dear Sir or Madam:
[1] This is in response to a request for rulings as to the federal income tax consequences of a
participation in a proposed joint venture with physicians to operate a cardiac catheterization
laboratory.
FACTS
[2] A is a nonprofit general acute care hospital that has been recognized as exempt from federal
income tax under section 501(a) of the Internal Revenue Code as an organization described in
section 501(c)(3) of the Code. It has been classified as other than a private foundation under
section 509(a)(1) as a hospital described in section 170(b)(1)(A)(iii). The sole member of A is C,
which is an organization that is described in section 501(c)(3).
[3] B is a health care organization that supports A in the provision of health care services. B is a
nonprofit organization that has been recognized as exempt from federal income tax under section
501(a) of the Code as an organization described in section 501(c)(3). It has been classified as other
than a private foundation as a supporting organization described in section 509(a)(3). C serves as
the sole member of B.
[4] A currently owns and operates 6 cardiac catheterization laboratories. All are located within A
in contiguous rooms. The 6 cardiac catheterization laboratories share a common waiting area for
patients as well as a common scrub area for physicians, nurses and other medical personnel
working in the laboratories.
[5] B is planning to develop and operate a seventh cardiac catheterization laboratory (the "Lab") to
serve as a dedicated outpatient laboratory through a joint venture with cardiologists who have staff
privileges at A. B and A formed D, a limited liability company.
[6] Initially, B and A will be the only members of D because, at the time D was formed, a limited
liability company formed under state law was required to have at least 2 members. Once the
physicians participating in the joint venture are admitted to D, A will withdraw from D and will be
paid the positive amount of its capital account.
[7] Physicians who will be allowed to hold membership interests ("the Physician Group") will be
members of the active medical staff of A with unrestricted privileges to conduct cardiac
catheterization procedures. It is anticipated that as many as twenty-four physicians representing as
many as five practice groups will participate in the ownership of the facility.
[8] B will hold at least a 52 percent membership interest and the Physician Group will hold no
more than a 48 percent membership interest in D. Pursuant to the Operating Agreement, B and the
Physician Group will make contributions in cash to D in proportion to their membership
interests.
[9] The Physician Group's cash contributions to D will entitle the physicians to membership
interests in D. Up to 24 units of membership interests (representing up to an aggregate 48 percent
membership interest) are being offered to physicians within the Physician Group at a cash
purchase price of $ 20,000 per unit as a capital contribution to D. Units not initially sold to
physicians within the Physician Group will be acquired by B and may be sold by D in the future to
additional physicians in the Physician Group on terms deemed acceptable to D at the time of the
sale.
[10] Ownership interests are proportional to and equal in value to their respective contributions.
All financial arrangements between M and the physician members will be negotiated on an
arm's-length basis and will be based on fair market value.
[11] Capital contributions to D and allocations of income, loss, deduction and credits will be in
proportion to the members' percentage interests in D. There will be no special allocations of
income or loss to any particular member of D. In the event of dissolution, following the payment
of all debts and liabilities of D and the allocation of income, profits, losses and deductions, and
after adjustments to the capital accounts required by applicable income tax regulations, the
remaining funds will be distributed to the members to the extent of, and in proportion to, their
positive capital account balances.
[12] B will enter into a development agreement with D in which it will provide development
services with respect to the Lab. The Agreement shall continue until the date the first procedure is
performed at the Lab. The development fee paid will be fair market value.
[13] Each member shall have voting rights equal to the member's percentage interest. A quorum
is present at a meeting of the members if members holding more than 50 percent of the percentage
interests of all the members are represented at the meeting. The board of governors and the
managers may not make certain decisions without the approval of members holding more than 50
percent of the percentage interest of the members. These decisions include (a) amending the
Operating Agreement and the Articles of Organization; adopt any new or changes to existing
long-term or master institutional or strategic plans for D; merge D with or consolidate D into any
other entity; organize or acquire any subsidiary or affiliate of D; and sell, assign or otherwise
transfer all or substantially all of the assets of D.
[14] Management of the business and affairs of D will be vested in the board of governors and its
managers. The Operating Agreement provides for a board of governors of 5 members, 3 of whom
are appointed by B and 2 of whom are appointed by the Physician Group. If new members are
appointed, they must be added in groups of 2, 1 appointed by B and 1 appointed by the Physician
Group, so that a majority of the board of governors will always be appointed by B. The presence of
3 governors at a meeting constitutes a quorum. All matters that come before the board are decided
by a majority vote.
[15] The board of governors cannot approve or engage in certain activities without prior approval
of B or those exempt entities that control B. These activities include approval of debt or the
expenditure of funds in excess of limits specified by C. The Operating Agreement provides that
the decision of the board of governors or the managers to forego any activity or action which fails
to gain the requisite approval from B shall not be a breach of the duty of loyalty of the board of
governors or the managers to D or D's members.
[16] B's board representatives will be persons from the community with experience in health care
matters, including officers and board members of A or B. They will not be on the medical staff of
D or of A. None of the officers, board members, or key employees of B or A that were involved in
the negotiations or decision-making process to form D were promised employment or other
inducement, including monetary, in regard to the formation of D.
[17] The managers are the executive officers. The board of governors elects the managers. The
board of governors may remove any manager with or without cause and such removal shall be
without prejudice to the contract rights, if any, of the manager so removed.
[18] A will provide services and staff to D, pursuant to a services agreement. These services and
staff will include personnel necessary to operate the Lab, equipment maintenance, certain
administrative services, and billing services.
[19] The Operating Agreement provides that the purpose of D is to develop, own and operate an
outpatient catheterization center, to promote health and to provide services to individuals referred
to the Lab without regard to race, creed, national origin, gender, payor source or the ability to pay
for services, and to provide health care services in a manner that furthers charitable purposes by
promoting health for a broad cross section of the community. It further provides that these
charitable purposes take precedence over any profit-making motive. The members acknowledged
and agreed that placing charitable purposes over profit-making motives is not a breach of duty of
loyalty of the board of governors or its members. These overriding charitable purposes are legal,
binding and enforceable under the state limited liability law.
[20] D has applied for and received a certificate of need from the state. The Lab is to be designed
and is intended to serve relatively low risk patients on an outpatient basis exclusively. The
determination of whether a patient is a candidate for cardiac catheterization at the Lab as opposed
to the existing cardiac catheterization laboratories currently operated by A will be based on criteria
developed by the American College of Cardiology. The criteria applied will generally insure that
the patients will not require hospitalization associated with the diagnostic procedures. The
procedures to be performed will be those which are typical and appropriate for low risk outpatient
diagnostic studies.
[21] The primary purpose of developing the Lab is to expand existing cardiac catheterization
services offered at A by providing improved patient care and service by segregating the low risk
outpatient modalities from the current inpatient facilities, thereby greatly increasing the
convenience to the patients who undergo testing in the Lab, as well as the patients' families. As
compared to the existing cardiac catheterization laboratories, which currently perform testing for
both low risk and higher risk patients, the Lab will be able to more reliably schedule procedures
and more reliably maintain such schedules. Patients who will undergo testing in the Lab will not
be subject to the risk of being "bumped" by emergency or higher risk patients or patients who
while undergoing testing may require supplemental interventional and therapeutic procedures
which are longer in duration and more difficult to predict and schedule.
[22] The Lab will provide services to all patients, including Medicare, Medicaid and indigent
patients. There will be no difference in the provision of services to Medicaid or indigent patients
from those provided to other patients. The indication of the percentage of indigent patients
expected to be served by the Lab is based on the percentage of indigent patients historically
provided with the outpatient cardiac catheterization services at A. The population served by
providers of outpatient cardiac catheterization services tends to be older and therefore more likely
to be covered by Medicare. In addition, health care providers in the state where D is located tend
to provide a lower percentage of indigent care than providers in other states due to the state system
of managed care which extends health coverage not only to the traditional Medicaid population,
but also to people who might otherwise have been considered indigents. D's charity care policy
will be made known to patients.
[23] The Lab will be located on the second floor of A's diagnostic and treatment wing on the main
campus near the emergency room entrance. Patients will have easy access to the Lab, which will
be at grade level adjacent to surface parking. The Lab will consist of the laboratory proper, a
registration and waiting area for patients and their companions, and an area for patient staging.
The laboratory proper will contain a catheterization procedure room, a control room, an equipment
room, 7 pre- and post-procedures recovery rooms, a nursing station, a scrub area, storage, and staff
and patient rest room facilities.
[24] D will lease the space from A at a competitive fair rental value. The lease will be for an initial
term of 10 years, with an option to renew the lease for an additional term of 10 years.
[25] Physician privileges at D are not dependent on owning a membership interest in D. Medical
staff members apply for and are granted privileges at the facility based on credentialling criteria.
[26] The following rulings have been requested:
1. Whether the creation of D, B's execution of the Operating Agreement and related agreements,
the carrying out of the transaction as contemplated by such agreements, and B's participation in the
ownership and operation of D will, either alone or collectively, adversely affect the status of B as
exempt from federal income tax under section 501(a) as an organization described in section
501(c)(3) or its classification as other than a private foundation as described in section
509(a)(3).
2. Whether the creation of D, A's execution of the Operating Agreement and related agreements,
the carrying out of the transactions by A as contemplated by such agreements, A's participation in
the ownership and operation of D until the admission of the Physician Group into D, will, either
alone or collectively, adversely affect the status of A as exempt from federal income tax under
section 501(a) as an organization described in section 501(c)(3) or its classification as other than a
private foundation as described in section 509(a)(1) and 170(b)(1)(A)(iii).
3. Whether the transfer of assets and resources by B to D, the distributive share of profits and
losses received by B with respect to its membership interest in D, or the payments received by A
pursuant to the lease agreement will result in unrelated business taxable income pursuant to section
511 of the Code to B or to A.
APPLICABLE LAW
[27] Section 501(c)(3) of the Code describes as exempt from federal income tax, as provided
under section 501(a), organizations organized and operated exclusively for charitable, scientific, or
educational purposes, no part of the net earnings of which inure to the benefit of any private
shareholder or individual.
[28] Section 1.501(c)(3)-1(a)(1) of the Income Tax Regulations provides that in order for an
organization to be exempt as one described in section 501(c)(3) of the Code, it must be both
organized and operated exclusively for exempt purposes. Under section 1.501(c)(3)-1(d)(1)(1)(b)
of the regulations, an exempt purpose includes a charitable purpose.
[29] Section 1.501(c)(3)-1(c)(1) of the 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 exempt purposes. An organization will not be so regarded if more
than an insubstantial part of its activities is not in furtherance of an exempt purpose. See Better
Business Bureau of Washington, D.C. Inc. v. United States, 326 U.S. 279, in which the Supreme
Court held that the presence of a single nonexempt purpose, if substantial in nature, will destroy a
claim for exemption regardless of the number or importance of truly exempt purposes.
[30] Section 1.501(c)(3)-1(d)(1) of the regulations provides that an organization is not organized
or operated exclusively for an exempt purpose unless it serves a public rather than a private
interest. Thus, an organization must establish that it is not organized or operated for the benefit of
designated individuals.
[31] Section 1.501(c)(3)-1(d)(2) of the regulations provides that the term "charitable" is used in
section 501(c)(3) of the Code 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 Scott and Fratcher, The Law of Trusts, sections 368, 372 (4th ed. 1989).
[32] Rev. Rul. 69-545, 1969-2 C.B. 117, provides that a nonprofit corporation whose purpose and
activity are providing hospital care is promoting health and therefore furthers charitable purposes
as provided in section 501(c)(3) of the Code if it meets the community benefit requirements. The
community benefit standard focuses on a number of factors indicating the operations of a hospital
benefit the community rather than serve private interests.
[33] Rev. Rul. 78-41, 1978-1 C.B. 148, concludes that a trust created by a hospital to accumulate
and hold funds to pay malpractice claims against the hospital qualified for exemption under section
501(c)(3) of the Code as an integral part of the hospital. The hospital provided the funds for the
trust, and the banker-trustee was required to make payments to claimants at the direction of the
hospital. The organization conducted an activity that the hospital could perform itself.
[34] Rev. Rul. 98-15, 1998-1 C.B. 718, compares two situations where an exempt hospital forms
a joint venture with a for-profit entity and then contributes its hospital and all of its other operating
assets to the joint venture, which then operates the hospital. In Situation 1, the revenue ruling
concludes that the exempt organization will continue to further charitable purposes when it
participates in the joint venture. Favorable factors include: the commitment of the joint venture to
give charitable purposes priority over maximizing profits; the community make-up and structure
of the board; the voting control held by the exempt organizations' representatives on the board; the
specifically enumerated powers of the board; and, the reasonable terms and conditions of the
management contract. In Situation 2, the revenue ruling concludes that the organization fails the
operational test when it participates in the joint venture because activities of the joint venture will
result in greater than incidental private benefit to the for-profit partner.
[35] Section 509(a)(1) of the Code excludes from the definition of private foundation those
organizations described in, among others, section 170(b)(1)(A)(iii). Section 170(b)(1)(A)(iii)
described an organization whose principal purpose or function is to provide medical or hospital
care.
[36] Section 509(a)(3) of the Code excludes from the definition of private foundation those
organizations that are (A) organized, and at all times thereafter are operated, exclusively for the
benefit of, to perform the functions of, or to carry out the purposes of one or more specified
organizations described in paragraph (1) or (2); (B) operated, supervised, or controlled by or in
connection with one or more organizations described in paragraph (1) or (2); and (C) not
controlled directly or indirectly by one or more disqualified persons other than foundation
managers and other than one or more organizations described in paragraph (1) or (2).
[37] Section 511 of the Code imposes a tax on the unrelated business income of organizations
described in section 501(c).
[38] Section 512(a)(1) of the Code defines unrelated business taxable income as the gross income
derived from any unrelated trade or business regularly carried on, less the allowable deductions
that are directly connected with the carrying on of the trade or business, both computed with
certain modifications.
[39] Section 512(c)(1) of the Code provides that if a trade or business regularly carried on by a
partnership of which an organization is a member is an unrelated trade or business with respect to
such organization, such organization in computing its unrelated business taxable income shall
include its share (whether or not distributed) of the gross income of the partnership from such
unrelated trade or business and its share of the partnership deductions with such gross income.
[40] Section 513(a)(1) of the Code defines 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 its makes of the profits derived) to the exercise or performance by such
organization of its exempt purposes.
[41] Section 1.513-1(d)(1) of the regulations provides that gross income derives from "unrelated
trade or business," within the meaning of section 513(a), if the conduct of the trade or business
which produces the income is not substantially related (other than through the production of
income) to the purposes for which exemption is granted. This requirement necessitates an
examination of the relationship between the business activities that generate the particular income
in question and the accomplishment of the organization's exempt purposes.
[42] Section 1.513-1(d)(2) of the regulations provides that to be substantially related to the
exempt purposes of the organization, the business activity must have a causal relationship to the
achievement of exempt purposes and it must contribute importantly to the accomplishments of
those purposes.
ANALYSIS
[43] Under the regulations, an organization that is organized and operated exclusively for
charitable purposes may qualify for exemption under section 501(c)(3) of the Code. The
promotion of health has long been recognized as a charitable purpose.
[44] Whether a hospital or other health care organization promotes health in a charitable manner
is determined under the community benefit standard of Rev. Rul. 69545, supra. This standard
focuses on a number of factors to determine whether the hospital benefits the community as a
whole rather than private interests.
[45] For federal income tax purposes, the activities of a partnership are considered to be the
activities of the partners. See Butler v. Commissioner, 36 T.C. 1097 (1961), acq., 1962-2 C.B. 4.
Aggregate treatment is also consistent with the treatment of partnerships for purposes of the
unrelated business income tax under section 512(c) of the Code. In light of the aggregate principle
discussed in Butler v. Commissioner 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) of the regulations.
Thus, the activities of a limited liability company treated as a partnership for federal income tax
purposes are considered to be the activities of a nonprofit organization that is a member of the
limited liability company when evaluating whether the nonprofit organization is operated
exclusively for exempt purposes within the meaning of section 501(c)(3).
[46] A section 501(c)(3) organization may form and participate in a partnership, including a
limited liability company 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 purposes and only incidentally for the benefit of the for-profit partners. See Rev. Rul.
98-15, supra.
[47] Based on Rev. Rul. 98-15, supra, whether a nonprofit organization whose principal activity is
the ownership of a membership interest in a limited liability company that is engaged in health
care activities satisfies the community benefit standard depends on all the facts and circumstances.
[48] Following the formation and operation of D, B will continue to be primarily involved in
serving the needs of A in a manner similar to that described in Rev. Rul. 78-41, supra. In addition,
B's participation in D will further its exempt purposes. B's participation in and operation of the
cardiac facility will promote health for the community in a manner that satisfies the requirements
of Rev. Rul. 69-545, supra. The structure of D and operation of the cardiac facility will allow B to
act exclusively in furtherance of charitable purposes with no undue private benefit to the physician
members.
[49] B will always own at least a 52 percent membership interest in D, so B will have voting
control over decisions made by the members. B will always have a voting control over major
decisions of the board of governors under the Operating Agreement. B will have 3 of the 5 total
votes of B's board of governors, and a majority of votes is needed to approve decisions. The board
of governors oversees the management of the business and affairs of D and elects the managers.
Thus, B will exercise effective control over the major decisions of D and over the operations and
activities of the Lab. This control will ensure that the assets that A and B own through D and the
activities conducted through D will be used primarily to further exempt purposes.
[50] Similarly, in Situation 1 of Rev. Rul. 98-15, the LLC is majority owned by the section
501(c)(3) hospital. A governing board consisting of 3 individuals chosen by the section 501(c)(3)
hospital and 2 individuals chosen by the for-profit organization manages the LLC. A majority of
the board must approve certain major decisions. Through the hospital's effective control over the
LLC's governing board and decisionmaking structure, the hospital could ensure that the assets it
owned through the LLC and the activities it conducted through the LLC would be used primarily
to further exempt purposes.
[51] Contributions to D and allocations of profits, losses, and distributions from it will be in
proportion to the interests of the members of D. With respect to termination, following the
payment of all debts and liabilities of D and the allocation of income, profits, losses and
deductions, remaining funds will be distributed to the members in payment of the amount of their
capital accounts. As a limited liability company, no owner of D will be personally liable for the
debts and obligations of D. Similarly, in Situation 1 of Rev. Rul. 98-15, profits and losses were
allocated in proportion to the interests of the members.
[52] The Operating Agreement specifically provides that the duty of the members and the board
of directors is to operate D in a manner that furthers charitable purposes by promoting the health
of a broad cross section of the community and that this duty overrides any duty to operate D for
the financial benefit of its members. Similarly, in Situation 1 of Rev. Rul. 98-15. the LLC's
governing documents committed the LLC to provide health care services for the benefit of the
community as a whole and to give charitable purposes priority over maximizing profits for the
LLC's owners.
[53] A's and B's participation in the formation of D and D's operation of the Lab consistent with
its governing documents will further A's and B's charitable purposes and allow A and B to
continue to be operated exclusively for exempt purposes. D will have a charity care policy that is
made known to patients. The Lab will serve all members of the community needing medical care,
including Medicare, Medicaid and indigent patients. Similarly, in Situation 1 of Rev. Rul. 98-15,
all the facts and circumstances established that when the hospital participates in the formation of
the LLC and when the LLC operates in accordance with its governing documents, the hospital will
be furthering charitable purposes and will continue to be operated exclusively for exempt
purposes.
[54] Formation and operation of D will further A's and B's exempt purposes. The control B will
exercise will ensure that an exempt organization retains control of the Lab's operations and will
ensure that medical services will be provided in a charitable manner in order to promote health for
a broad cross section of the community regardless of ability to pay, including Medicare, Medicaid,
and indigent patients. B's ownership in D and A's ownership until the physician group is admitted,
will enable A and B to continue to promote health in a charitable manner. Because A's and B's
involvement in D furthers their charitable purposes, their participation is substantially related to
each of A's and B's exempt purposes, and does not result in unrelated business taxable income to
either A or B under sections 511 through 513 of the Code.
CONCLUSION
[55] Based on the facts and discussion above, we rule as follows:
1. The creation of D, B's execution of the Operating Agreement and related agreements, the
carrying out of the transaction as contemplated by such agreements, and B's participation in the
ownership and operation of D will not, either alone or collectively, adversely affect the status of B
as exempt from federal income tax under section 501(a) as an organization described in section
501(c)(3) or its classification as other than a private foundation as described in section
509(a)(3).
2. The creation of D, A's execution of the Operating Agreement and related agreements, the
carrying out of the transactions by A as contemplated by such agreements, and A's participation in
the ownership and operation of D until the admission of the Physician Group into D, will not,
either alone or collectively, adversely affect the status of A as exempt from federal income tax
under section 501(a) as an organization described in section 501(c)(3) or its classification as other
than a private foundation as described in section 509(a)(1) and 170(b)(1)(A)(iii).
3. The transfer of assets and resources by B to D, the distributive share of profits and losses
received by B with respect to its membership interest in D, or the payments received by A
pursuant to the lease agreement will not result in unrelated business taxable income pursuant to
section 511 of the Code to B or to A.
[56] This ruling is based on the understanding that there will be no material change in the facts
upon which it is based. Any changes that may have a bearing on your tax status should be reported
to the Service. This ruling does not address the applicability of any section of the Code or
regulations to the facts submitted other than with respect to the sections described.
[57] This ruling is directed only to the organization that requested it. Section 6110(k)(3) of the
Code provides that it may not be used or cited as precedent.
[58] Because this letter could help resolve future questions about your income tax responsibility,
please keep a copy of this ruling in your permanent records. If you have any questions about this
ruling, please contact the person whose name and telephone number are shown in the heading of
this letter.
[59] We have sent a copy of this letter to your authorized representative as indicated in your
power of attorney.
Sincerely,
Marvin Friedlander
Manager, Exempt Organizations
Technical Group 1
**************** End of Document ****************
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