February 22, 2018
With shrinking resources and increasing demand, many health systems are considering ancillary joint ventures with physicians or other entities as a way to improve efficiency and expand services. Joint ventures can also be a viable way to enter markets not otherwise accessible, align with physicians, build system service lines and better prepare for population health management. However, for tax-exempt hospitals and their health systems, there are important issues that need to be addressed to ensure the joint venture does not threaten your tax exempt status.
An ancillary joint venture usually involves creating a new legal entity treated as a partnership for tax purposes, such as a limited partnership or limited liability company. If the joint venture occurs between a tax-exempt hospital and a for-profit entity, the following need to be addressed to avoid impacting tax-exempt status.
Beware of inurement
Tax-exempt organizations are prohibited from providing private inurement. Inurement is the use of the assets or earnings of an exempt organization to benefit an insider of the organization. An insider of the hospital can include an officer, director or someone with control over certain aspects of the operations. If insiders are participants in the joint venture with the hospital, care must be taken to ensure that improper benefits do not arise through favorable terms in the arrangement or unreasonable compensation.
Maintain charitable purpose
An exempt organization can participate in joint ventures with for-profit partners without adversely affecting its tax-exempt status, assuming the activity of the joint venture is not a substantial part of its overall operations. If the activity is substantial, the joint venture needs to be structured to further charitable purposes or the venture could impact its exempt status. If the joint venture is not substantial and does not further charitable purposes, it will be treated as unrelated business income.
Avoid private benefit
If the venture has a charitable purpose, the nonprofit must be able to enforce the charitable purpose in order to ensure the activity is charitable. Failure to enforce a charitable purpose can result in private benefit, i.e., benefiting a private entity versus the public. If private benefit is provided, the activity will become taxable. Significant private benefit could result in loss of tax exempt status. One way to avoid private benefit is to structure the joint venture so that the nonprofit controls the operations either via board control or control of operational aspects.
Monitor unrelated business income
Unrelated trade or business income is income from activities that are not substantially related to the tax exempt purpose of the organization. Unrelated business income is taxed at normal tax rates. Most joint ventures are treated as partnerships for tax purposes. To determine the tax treatment, the purpose of the underlying activities is evaluated. If the activity does not further charitable purposes either by the type of activity or because there is private benefit, the activity will generate taxable income to the hospital. A nonprofit entity is allowed to have unrelated business activities as long as the unrelated activity is not substantial to the overall activities.
Adhere to IRC 501(r)
Regulations under IRC 501(r) regarding tax exemption under 501(c)(3) for an entity that operates hospital facilities also apply to hospital facilities operated within a joint venture. Unless the 501(c)(3) entity treats the income generated by the hospital facility as unrelated business income, the hospital facility must follow the 501(r) rules. This means that a hospital owned jointly by a 501(c)(3) entity and a taxable entity will need to conduct a community health needs assessment, have a financial assistance policy, limit charges and have billing and collection policies.
A few other considerations
In addition to these issues that impact the tax-exempt status, there are other operational issues to be considered including:
Joint ventures with physicians come with their own special considerations. Such transactions need to be structured in light of Stark and anti-kickback rules. Stark prohibits physicians from referring patients to an entity in which they have an ownership interest or compensation arrangement for designated health services covered by Medicare and Medicaid. The anti-kickback rules prohibit the exchange of something of value for referrals. Both sets of rules have exceptions that can be met for certain employees, personal service arrangements and space and equipment rental agreements. In addition, an exception exists under the Stark rules for rural providers.
Increased operating costs due to taxes
The cost of operating a service line as part of a joint venture may be higher than operating it directly by the hospital itself due to the potential loss of property tax and sales tax exemption. Sales tax and property tax exemptions provided to nonprofit organizations typically are not applicable to a joint venture. This is especially true when the joint venture involves a for-profit partner.
Tax-exempt bond issues
It’s also important to note that conducting activities of a joint venture within tax-exempt bond financed facilities could have an impact on the outstanding bonds held by the hospital and result in private business use. Care should be taken in leasing hospital space to the joint venture if there is debt outstanding on the facility.
Joint ventures are an important strategic alternative for hospitals and health systems as they address their care delivery needs of the future. However, it is important to structure these correctly to ensure potential tax complications are avoided.