Formation of hybrid-type organizations: virtual mergers of health care systems.

• Author: Lockman, Stuart M.
• Position: Florida

This article addresses emerging models of affiliations in the health care industry. It discusses some of the legal issues involved in the structuring and operation of such models with a focus on the concerns of tax-exempt health care systems.

Affiliations among health care systems are a necessary part of doing business in the 1990s. Through affiliations, these systems are able to eliminate unnecessary duplication by consolidating services to reduce costs. At the same time, such affiliations enable systems to improve health care quality and access. Affiliations also provide systems a structure by which they not only can leverage market position by engaging in single signature contracting but also can support the physician integration necessary for their managed care contracting initiatives.

Today, health care systems frequently are forgoing traditional mergers and consolidations in favor of forming hybrid-type organizations (HTOs). HTOs include joint operating agreements (JOAs) and unusual forms of holding companies. Systems prefer HTOs rather than traditional mergers or consolidations for a number of reasons, including where an affiliation involves less than all of a health care system's hospitals or different geographic areas; where significant local autonomy is desired; where advantageous third party-payment rates need to be preserved; where obligated group financing precludes transfers of assets; where the parties wish to avoid the assumption of unknown liabilities; and where the HTO involves religious issues.

HTOs typically take the form of either a JOA or a holding company model. A JOA consists of a contractual arrangement which may, but need not, involve the creation of a separate corporation, partnership, or-limited liability company (JOC) to oversee the operations of the participating health care systems. Each participant retains ownership of its assets and continues to be liable for its own liabilities. For the tax and antitrust reasons described below, however, the participants' operations are both financially and structurally integrated. A "virtual" merger of the participants' operations occurs.

HTOs also can take the form of various holding company models. The participants often are subsidiaries of the holding company. The responsibility for appointment and removal of the governing boards and for the day-to-day operations of the holding company and its participants may be allocated among them in any number of ways agreed upon by the parties.[1]

Tax Considerations

If the HTO participants are exempt from federal income taxation under [sections] 501(c)(3) of the Internal Revenue Code of 1986, the HTO must be structured so as not to affect adversely that tax-exempt status. Several key tax questions[2] exist in such a transaction.

The answers to these tax questions turn on the analysis outlined in the Internal Revenue Service's Continuing Professional Education Text for Fiscal 1997.[3] With respect to a JOA, the JOA must effect a sufficient integration of the JOC and the operations of the tax-exempt participants so that the parties may be considered related with respect to the activities undertaken pursuant to the JOA. The type of integrated relationship the IRS requires is one in which the aspects of shared governance and control ("structural integration") and shared economic risk and reward ("financial integration") are comparable to those present in a typical parent-subsidiary relationship.[4]

We should mention that the holding company model raises a number of other tax considerations.[5] An analysis of these concerns is beyond the scope of this discussion.

Antitrust Considerations

Federal antitrust laws make it per se illegal for competitors to agree on prices or pricing terms,[6] unless such an agreement is part of a "legitimate," economically integrated joint venture, with the potential of creating economic efficiencies.[7] For this reason, the parties should conduct an integration analysis to determine whether the participants will be deemed to be a single economic entity, rather than competitors. The participants may agree on prices if their...