Busting Myths: Joint Ventures
Radiology groups should understand the tax implications of arrangements with hospitals before they begin negotiations, according to W. Kenneth Davis, Jr, JD. He presented Tax-exempt Laws and Radiology Groups: Myth Versus Reality on October 17, 2008, at Managing Legal Exposure in Radiology, a meeting held in Philadelphia by the RBMA. Davis, a partner in Katten Muchin Rosenman, Chicago, explains that using the wrong approach to joint ventures and contracts with tax-exempt hospitals can have highly undesirable consequences for a radiology group. Because there is so much misunderstanding of the 501(c)(3) tax exemption for hospitals, the radiology group should protect itself from unpleasant surprises by knowing the legal requirements imposed on hospitals and their effects on the physician groups that work with them.
W. Kenneth Davis, Jr, JDAs federal and state scrutiny of hospitals’ tax exemption becomes more intense, the need for caution in designing joint ventures and contracts will only increase, Davis says. The tax treatment afforded hospitals has never been questioned as often, or as closely, as it is today. The attorneys general of some states are investigating whether tax-exempt hospitals actually provide the community benefits on which their state tax exemptions are based. Davis adds that, at the federal level, influential legislators are trying to determine whether more uncompensated care should be required in exchange for hospitals’ federal tax exemptions. Understandably, these trends have made hospitals highly aware of the need to protect their tax-exempt status. If it is threatened, they may lose not only the ability to avoid taxation of their income, but the chance to obtain charitable contributions; the donations on which many hospitals depend are unlikely to be made if the donors will not be granted any tax deductions for their gifts. In addition, hospitals often depend on tax-exempt bonds for access to capital. If a hospital’s agreements with a radiology group have been structured with the proper attention to remaining above suspicion, exemption challenges can be avoided. If mistakes have been made in contracting, however, the hospital may be placed in a position where it can avoid penalties only at the expense of the radiology group—and that expense may be large, if the group cannot document the fair market value of its transactions with the hospital. Davis points out the importance, in negotiations, of distinguishing between real legal issues and those that are actually business concerns that the tax-exempt hospital may present as legal problems related to tax exemption. The 501(c)(3) exemption requires the hospital to be operated for charitable purposes, to avoid political campaigning or substantial lobbying, to serve public (not private) interests, and to serve patients who are unable to pay, as well as all of those who are able to pay, including Medicaid/Medicare enrollees. Charitable purposes can include medical education, training, and research, in addition to health care. The hospital’s board must represent the community; its medical-staff enrollment must be open; and its profits must be used for patient care, facility improvements, and equipment, not private benefit. Of course, a hospital would be unable to serve its charitable purpose unless it conferred some private benefit on others (it must, after all, usually work with employees and contracted service providers). The hospital’s earnings cannot, however, be distributed to individuals or groups or to those considered insiders (who are in positions to influence or control the hospital). Major contributors, board members, shareholders, officers, and founders are defined as insiders, but physicians may or may not be. Radiology and Tax Exemption For radiology groups, Davis says, the hospital’s tax-exempt status may be an issue in negotiating exclusive provider agreements, leases, gain sharing, service relationships, and joint ventures. Because radiology is associated with large investments in capital equipment, the use of tax-exempt bonds can cause problems. Private business use of more than 5% of the proceeds of a bond, or the property purchased with it, is forbidden, whether that use is direct or indirect. The effective limit may be as low as 3%, since up to 2% of the private-use 5% can be used to pay for the bond-related borrowing process. A management contract for bond-financed facilities may constitute private use, Davis says, and many bond counselors would define the exclusive provider agreements so often seen between hospitals and radiology groups as management contracts. The radiology group’s use of bond-financed imaging equipment, therefore, may be private business use. Most hospitals will, as a result, be careful to ensure that management contracts fall within the safe harbors established to permit the hospital to acquire services without risking its tax exemption. Transactions between exempt and nonexempt parties that convey excess benefit to the latter are subject to excise taxes. Excess benefit, Davis says, is defined as value provided that exceeds consideration received; for example, a lease that lets a radiology group use hospital property for less than fair market value could be considered excess benefit. Hospital managers and nonexempt parties are both subject to the excise tax, but the hospital itself is not. Because the hospital must report excess benefits and their correction to the IRS annually, it will attempt to show that the situation has been corrected. This is done by having the nonexempt party pay the hospital, in cash or cash equivalents, the value of the excess benefit plus interest. The hospital and the nonexempt party are both subject to per-diem fines until the correction amount has been paid. For this reason, Davis says, radiology groups must ensure that fair market value is assigned in all dealings with tax-exempt hospitals. Documentation of fair market value must be maintained, with outside appraisal suggested if high values are involved. Hospitals are under pressure from both lower reimbursement and greater regulatory scrutiny, so Davis says that they may be looking for instances of excess benefit aggressively, assigning high values to them, and calling for their correction by physician groups. This could be very costly to a radiology practice, so careful documentation is vital. Joint Ventures Davis calls joint ventures the legal category where radiology groups are most likely to benefit from a myth-busting look at the tax-exemption law. The two areas of concern for a tax-exempt hospital that hopes to structure a joint venture with a group of physicians—without jeopardizing its 501(c)(3) status—are ownership and control, he says. A whole-hospital joint venture involves the transfer to the new entity of all assets belonging to the tax-exempt hospital, along with all of its operations. Typically, the original hospital then ceases to exist apart from the joint venture. Until 1998, the IRS applied a simple two-part test to determine whether a joint venture of this kind qualified for tax exemption. First, an exempt purpose, such as health promotion, had to be furthered by the hospital’s participation. Second, the hospital had to act exclusively to further that exempt purpose, with any benefit to the physician group (or other for-profit party to the joint venture) being only incidental. The relative ease of compliance with these requirements ended a decade ago, when the IRS issued Revenue Ruling 98-15. This requires joint ventures to meet three additional criteria in order to remain tax exempt. Any profit-maximization purposes for which they are operated have to be superseded by charitable purposes, the community as a whole must benefit from the entity’s services, and the furtherance of charitable purposes by the joint venture has to be ensured by the tax-exempt partner. Davis reports that these three requirements are often met by structuring the whole-hospital joint venture so that the hospital is clearly in control of the new entity. Hospital subsidiary joint ventures involve the creation of a new entity for the express purpose of operating that entity jointly with an existing for-profit entity, such as a physician group. A legal precedent has been set in which the court ruled that the subsidiary of the hospital could not be regarded as tax exempt because the joint venture was being operated for a substantial nonexempt purpose (that is, for the financial benefit of the for-profit entity). Joint ventures of this type may be on shaky ground unless the hospital is demonstrably in control of the venture. The third kind of joint venture, the hospital ancillary joint venture, is an entity that has one for-profit entity, like the other two types; the hospital’s part, however, is taken by a hospital subsidiary or affiliate that has the joint venture as only one of its activities—and not as its primary activity, but as an insubstantial one. The main activities of the subsidiary/affiliate must be not only tax exempt, but unrelated to the joint venture. Davis describes deciding who controls this kind of joint venture as a big unanswered question. A Private Letter Ruling (number 200206058) was issued by the IRS in 2001 approving a joint venture of this kind, but 60% of the entity, in this instance, was controlled by a subsidiary of a tax-exempt hospital, making it compliant with the control requirements of the 1998 Revenue Ruling. Among the unknown factors affecting the tax status of this type of joint venture is the effect that a smaller percentage of hospital control would have. In addition, the amount of the hospital subsidiary’s activity that the joint venture represents may be important. As an example, Davis describes a situation in which the tax-exempt hospital subsidiary does not control the joint venture, but the joint venture represents only 5% of that subsidiary’s activities, with the other 95% of its activities being both tax exempt and unrelated to the joint venture. In such a case, the joint venture might pose no threat to the hospital’s tax exemption, but the profits that the joint venture earns for the hospital might or might not be treated as unrelated business taxable income (UBTI). Paying taxes on UBTI might be undesirable, but would jeopardize neither the hospital’s tax-exempt status nor its ability to attract tax-deductible donations and use tax-exempt bonds. A Private Letter Ruling issued by the IRS in 2004, which may be considered a precedent for hospital ancillary joint ventures, addressed a joint venture (selling video seminars for teacher training) between a tax-exempt university and a for-profit company. The joint venture was set up to divide equally the two partners’ investment, governance, ownership, returns, allocation, and distributions. For the university, the joint venture represented an insubstantial percentage of total activities; for this reason, its tax-exempt status was not jeopardized. In addition, the university was not required to pay UBTI taxes on its profits from the joint venture because its activities were considered substantially related to the purpose (education) for which the university had tax-exempt status in the first place. For most ancillary-services joint ventures (for example, imaging joint ventures) undertaken by a hospital and a radiology group, the same fundamental principles may apply, Davis says: The hospital’s activities will further its tax-exempt purpose (health care) and the joint venture will constitute an insubstantial portion of its total activities. Insubstantial, in such cases, may be defined as involving less than 15% of the hospital’s overall personnel, staff time, assets, revenue, and expenses; nearly all ancillary joint ventures with radiology groups will meet these criteria. The hospital’s 501(c)(3) tax exemption and incoming charitable donations, therefore, will not be at risk. The real tax-related concern for hospitals is whether its income from the joint venture will be taxed as UBTI. There is a simple test to determine this, Davis says. If the services provided by the joint venture are such that they would fall within the definition of the hospital’s charitable purpose if the hospital were to provide those services by itself (in the absence of any joint venture), then the profits are unlikely to be taxed as UBTI. There could be a problem, however, if the joint venture acts in some way that is inconsistent with the hospital’s tax-exempt purpose, and the hospital is unable to exercise any control over that inconsistent action. The hospital should have what Davis calls trump rights: the ability to prevent joint-venture actions that are incompatible with its charitable purpose (along with the ability to cause actions consistent with that purpose). For example, the joint venture must not discriminate in treating patients, and it should have a charity-care and/or community-benefit policy in place. The hospital should be allowed to modify that policy as needed to protect its tax exemption. The important message here, Davis says, is that the joint venture does not need to give any other rights to the hospital in the name of preserving the hospital’s tax exemption, so long as the hospital’s participation is insubstantial. If trump rights are provided, the hospital and the radiology group can own and control the joint venture equally. Davis adds that a 50–50 governance calls for the existence of a mechanism for resolving disputes, since neither party will be in sole control. Under a management services agreement, the hospital can choose to delegate much of the administrative responsibility for the joint venture to the radiology group (again, with the hospital’s trump rights preserved). It is also wise to anticipate future unfavorable regulatory changes by including, in the joint venture’s design, the ability to dissolve it equitably, should this become necessary. A mechanism through which the radiology group can obtain fair market value for any disadvantages created by the hospital’s exercise of its trump rights can also be part of the joint venture’s structure. As pressures favoring increased consolidation of radiology continue to grow, more hospitals and radiology groups are likely to evaluate their options not just in mergers and acquisitions, but in designing better hospital contracts and joint ventures. If both parties understand what they can expect to gain, as well as how to avoid unnecessary risks, these pursuits can create mutual benefit.
W. Kenneth Davis, Jr, JD