ST. DAVID'S HEALTH CARE SYSTEM WINS VICTORY IN JOINT VENTURE CASE

By LaVerne Woods and Robin Turner
[July 2002]

The IRS suffered a significant defeat in June when a U.S. District Court in Texas overturned the agency's revocation of tax exemption of St. David's Health Care System. St. David's had entered into a "whole-hospital" joint venture with for-profit partners. The partnership agreement gave St. David's and a for-profit partner equal board representation in the joint venture, but imposed certain safeguards designed to preserve the charitable nature of its operations. The IRS revoked St. David's exemption on the grounds that St. David's was no longer operated exclusively for charitable purposes and that it impermissibly furthered the interests of the for-profit partners. Rejecting the IRS's arguments, the court ordered the IRS to reinstate St. David's tax exemption under Section 501(c)(3).

Joint Venture Guidance

Joint ventures between tax-exempt organizations and for-profits have become everyday occurrences, particularly in the health care industry. The IRS concedes that Section 501(c)(3) organizations may enter into partnerships with for-profit entities without jeopardizing their exemption, depending on the facts and circumstances of the particular transaction. The parameters of what is permissible are elusive, however. The only published IRS guidance in this area is Revenue Ruling 98-15, which sets out two examples of whole-hospital joint ventures with for-profit corporations. One example presents "white" facts (never seen in an actual transaction) in which the exempt hospital has full control over the venture, while the other presents "black" facts in which the hospital cedes control to the for-profit partner. The ruling concludes that the first hospital continues to qualify under Section 501(c)(3), while the second hospital fails to qualify as a result of the joint venture. The ruling is of limited utility in structuring joint ventures in the real world, where the facts invariably fall somewhere in between the two examples.

The one published case in the area, Redlands Surgical Services, presented largely "black" facts. Both the Tax Court (in 1999) and the U.S. Court of Appeals for the Ninth Circuit (in 2001) upheld the IRS's denial of exempt status to the nonprofit participant.

Facts of St. David's

The St. David's case sheds light for the first time on the gray area between the examples in Revenue Ruling 98-15. St. David's had been exempt since 1938. In 1996, it entered into a limited partnership with two for-profit subsidiaries of HCA, Inc. St. David's contributed all of its hospital assets to the partnership, after which its sole activity was participating in the partnership. The for-profit partners also contributed hospital assets. St. David's received a 45.9 percent interest in the partnership, based on an independent valuation of the contributed assets. The partnership agreement gave equal board representation to St. David's and one of the for-profits. St. David's retained certain special rights, however, including the unilateral right to dissolve the partnership if it did not act in accordance with standards for tax exemption, the right to appoint the chairman of the board, and to terminate the chief executive officer.

In 2000 the IRS audited St. David's and revoked its tax exemption retroactive to the partnership's formation in 1996. The IRS maintained that St. David's no longer operated exclusively in furtherance of charitable purposes and that the partnership provided an impermissible level of benefit to the for-profit partners.

The Court's Analysis

The U.S. District Court for the Western District of Texas granted summary judgment for St. David's, rejecting all the IRS's arguments. The IRS first contended that a health care organization must have a "community board" to qualify under Section 501(c)(3), and that because a for-profit entity could appoint 50 percent of the joint venture's board, St. David's failed this test. The court ruled that "the presence of a community board is a point in favor of exemption, but it is not an absolute requirement for exemption." Even if a community board were a requirement, reasoned the court, St. David's satisfied the requirement. According to the court, the purpose of a community board is to ensure that the community's interests are given precedence over any private interests, and there are other mechanisms beyond voting membership in the board to achieve that result. The court cited St. David's rights to dissolve the partnership, appoint the chairman of the board, and terminate the chief executive officer as sufficient safeguards. Despite the 50-50 split of control of the partnership's board, the court found that St. David's had "substantially more control than the for-profit partners."

The court also rejected the IRS's position that St. David's, through the partnership, failed to provide sufficient charity care to qualify for exemption. The court instead formulated the issue as whether the joint venture provided emergency care to all who require it regardless of willingness or ability to pay. The court found that St. David's satisfied this standard.

Implications for Structuring Joint Ventures

The St. David's decision is a welcome development for tax-exempt organizations because it suggests that there is more flexibility in structuring joint ventures with for-profit entities than earlier guidance had indicated. Particularly encouraging is the court's recognition that the exempt partner's control over a majority of a joint venture's governing board is not necessary to ensure that the joint venture serves charitable purposes so long as other adequate protections are in place.

St. David's is by no means a license for exempt organizations to engage in aggressive joint ventures with for-profit partners, however. While the case may ultimately result in a more permissive approach to exempt/for-profit joint ventures, it is unlikely that the IRS defeat in St. David's will mean the end of IRS challenges in this area. The government is expected to appeal the trial court's decision to the U.S. Court of Appeals for the Fifth Circuit.

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Any questions about this Advisory should be directed to :

LaVerne Woods, Seattle, (206) 628-7792, lavernewoods@dwt.com
Robin Turner, Seattle, (206) 628-7729, robinturner@dwt.com

This TEO Group Alert is a publication of the Tax-Exempt Organizations Group of Davis Wright Tremaine LLP. Our purpose in publishing this Alert 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.

Copyright © 2002, Davis Wright Tremaine LLP. Please do not reprint, or post on your website, without explicit permission.

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