The Fifth Circuit's Decision in St. David's Health Care System: Control Is Key in Whole-Entity Joint Ventures With For-Profits.

By LaVerne Woods and Kristen Gurdin
[Winter 2003]

The IRS won a significant victory when the U.S. Court of Appeals for the Fifth Circuit vacated a Texas District Court's ruling in the St. David's Health Care System case in November 2003. The case raises the question of whether a tax-exempt hospital may continue to qualify for exemption if it enters into a "whole hospital" joint venture with a for-profit partner.

BACKGROUND

St. David's, a tax-exempt hospital in Austin, Texas, entered into a limited partnership with Columbia/HCA, a for-profit company, in 1996. St. David's contributed all of its hospital assets to the partnership and afterwards participated in the partnership as its sole activity.

The IRS audited St. David's in 1998 and in 2000 revoked its tax-exempt status under Section 501(c)(3) retroactive to the date the partnership was formed. The IRS asserted that under the joint venture arrangement St. David's had ceded control over its operations to the for-profit partner, and therefore was no longer operated for charitable purposes. St. David's successfully challenged the revocation in federal district court in the Western District of Texas. The trial court ruled that St. David's continued to qualify under Section 501(c)(3) following its participation in the joint venture.

On appeal, the IRS argued that St. David's had the burden of demonstrating both that the partnership's activities further charitable purposes, and that the structure of the joint venture does not provide any substantial level of private benefit to the for-profit partner. According to the IRS, St. David's could not show that it engages primarily in charitable activities because it had not retained sufficient control over the joint venture. St. David's argued that the central issue was not control, but rather whether the partnership engaged in activities that furthered exempt purposes.

The Fifth Circuit acknowledged that the partnership performed some charitable functions, but agreed with the IRS that control is a key factor. The court remanded the case to the district court for further proceedings.

THE COURT'S PRAGMATIC CONTROL ANALYSIS

The Fifth Circuit's approach to control is highly factual and pragmatic, examining both St. David's rights under the transaction documents and the overall context of the joint venture. The partnership agreement provided for equal board representation by St. David's and Columbia/HCA, but reserved certain powers to St. David's. St. David's had the unilateral right to appoint the chairman of the board. The Fifth Circuit found that this right conveyed no real authority, given that the chairman had no power to make decisions or initiate actions. The 50/50 board representation gave St. David's the power to veto actions, but not to initiate them without the support of the for-profit partner. St. David's therefore could not ensure that the partnership would take new action to further charitable purposes. The court stopped short of stating that the nonprofit partner must appoint a majority of the board in order to demonstrate control, however.

The partnership contracted with a for-profit subsidiary of Columbia/HCA to manage day to day operations. The partnership agreement required the manager to comply with the charitable community benefit standard, and gave St. David's the power to enforce the requirement through legal action. The court questioned whether St. David's would resort to litigation every time the manager made a decision that conflicted with the community benefit standard.

St. David's in addition had the power to terminate the CEO and to dissolve the partnership if St. David's continued involvement in the partnership would threaten its tax-exempt status. In assessing the level of St. David's control over the CEO, the court looked to past dealings. While the partnership required the CEO to provide the board with an annual charity care report, the CEO had never done so prior to the IRS audit. St. David's inability to enforce that provision raised doubts about its ability to ensure that the partnership's operations further charitable purposes. The court also questioned whether St. David's would exercise its option to dissolve the partnership, given that the partnership agreement prohibited both partners from competing in the Austin area for two years after dissolution. This non-compete would effectively destroy St. David's, which serves only the Austin community, while it would be only "slightly unpleasant" for Columbia/HCA.

IMPLICATIONS FOR THE FUTURE

St. David's is an important test case in the uncertain legal terrain of joint ventures between tax-exempt organizations and for-profit entities. While the Fifth Circuit's decision is technically binding only in Mississippi, Louisiana and Texas, it adds judicial weight to the IRS position, set out in Revenue Ruling 98-15, that an exempt organization must retain control over a whole-entity joint venture in order to retain tax exemption. The court's decision cites with approval a similar analysis in the Ninth Circuit's 1999 opinion in Redlands Surgical Services. That decision upheld the IRS's denial of exemption to a healthcare organization that participated in a joint venture with a for-profit entity as its sole activity.

While the Fifth Circuit opinion does not reach the ultimate issue of whether St. David's continues to qualify for exemption, it sends a clear message that an exempt organization engaging in a joint venture with a for-profit entity as a substantial portion of its activities must ensure that it has a good measure of practical -- and not merely theoretical -- control in order to maintain its tax exemption.

This TEO Advisory Bulletin is a publication of the Tax-Exempt Organizations Group of Davis Wright Tremaine LLP. Our purpose in publishing this Advisory is to inform our clients and friends of recent developments in tax-exempt and nonprofit organizations law. It is not intended, nor should it be used, as a substitute for specific legal advice as legal counsel may only be given in response to inquiries regarding particular situations.

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