Perils of Use of For‐Profit Management Company Illustrated

• Published date: 01 January 2018
• Date: 01 January 2018
• DOI: http://doi.org/10.1002/npc.30415

Bruce R. Hopkins’ NONPROFIT COUNSEL

January 20184THE LAW OF TAX-EXEMPT ORGANIZATIONS MONTHLY

Bruce R. Hopkins’ Nonprofit Counsel DOI:10.1002/npc

The provisions concerning modification of the inter-

mediate sanctions rules, art museums as private operat-

ing foundations, an exception from the excess business

holdings rules, the additional reporting requirements for

sponsoring organizations, elimination of tax exemption for

sports leagues, and the increase in the charitable giving

annual limit generate no or negligible revenue losses. The

modification of the restriction on political campaign activity

by charitable organizations is said to decrease revenues by

$2.1 billion. ◆

PERILS OF USE OF FOR-PROFIT

MANAGEMENT COMPANY

ILLUSTRATED

The IRS, presented with an extreme set of facts, ruled

that a rural acute care hospital must have its tax exemp-

tion revoked because it transferred excessive operational

control over the hospital’s operations to a for-profit

management company, thereby ceding “complete con-

trol” of itself to the company and maintaining merely an

“advisory role” (Priv. Ltr. Rul. 201744019).

Facts

This hospital gained recognition of tax exemption in

1989. It began operations as a general hospital in a rural

community. Later, facing financial difficulties, the hospital

transferred its operations to a local board. An agree-

ment was made with a for-profit management company,

whereby it would be responsible for day-to-day operations

of the hospital, with the hospital maintaining control. The

hospital timely filed annual information returns, reporting

these fact changes.

Thereafter, the hospital leased its land, equipment, and

other property to the company; the company operated

the hospital under another name. The ruling states that

the hospital “turned over control of all hospital operations

including collecting revenues” to the company. The lease

required the provision of charity care in a manner consistent

with the hospital’s prior practices.

Analysis

Relying heavily on its whole-hospital joint venture rul-

ing (Rev. Rul. 98-15), the IRS stated that the lease “gives

total operational control over it to the for-profit entity

which [e]nsures that profit maximization will be the guiding

principle under which the hospital operates, with the only

restrictions being the maintenance of an acute care hospital

and charity care policy.” The IRS dismissed the charity care

provision in the lease as being ineffectual, in that the hos-

pital lacks the ability to enforce it.

An exempt hospital’s “entire focus,” the IRS wrote,

“must be on community welfare.” This includes “determin-

ing the health needs of the community and enacting edu-

cational and other programs designed to both prevent and

address community health problems”—activities that for-

profit health care providers “do not involve themselves in

because they are a drain on the entity’s financial resources.”

[7.6, 28.3(b), 31.3]

Commentary: The true significance of this ruling is

application of the IRS’s analysis of joint venture arrange-

ments to a management company structure, reflected

in an ostensible lease. Yet it contains an oddity. As

noted, over the years, this hospital dutifully filed annual

information returns, chronicling its evolution. The IRS

observed that the institution “did not omit or misstate

a material fact.” Yet, wrote the IRS, it “operated in a

manner materially different from that originally repre-

sented” in its application for recognition of exemption.

Then came this: The hospital “did not formally notify

the Service of the change in activities, nor did it seek an

affirmation letter or private letter ruling to confirm that

it continued to qualify for exemption.”

The Form 990 is the “formal” way to report incre-

mental fact changes in exempt organizations’ operations

to the IRS. There are specific questions on the return

about this topic (Form 990, Part III, questions 2 and 3).

There is no requirement to otherwise notify the IRS of

changes in activities, nor is there any requirement to

seek a letter or ruling on the point from the IRS. The

latter may be a good idea (and an expensive one) in

appropriate circumstances but is not mandatory. ◆

FACIAL CHALLENGE

TO CALIFORNIA’S SCHEDULE B

DISCLOSURE RULE FAILS

The US District Court for the Eastern District of Califor-

nia, in an opinion dated October 31, dismissed a public

charity’s claim that the California attorney general’s Form

990, Schedule B filing requirement is facially unconstitu-

tional, principally as a transgression of free speech rights

(Center for Competitive Politics v. Harris).

Facts

The Center is a recognized public charity that raises

funds nationwide. It has been registered with the California

Registry of Charitable Trusts since 2008. The Center’s filing

in 2014 was deemed incomplete by the California attorney

general’s office because the filing included only a redacted

version of its Schedule B. The Center has ceased fundrais-

ing in the state, rather than comply with the disclosure rule.

The Center failed to convince the US Court of Appeals

for the Ninth Circuit of the merits of its assertion that the

Schedule B disclosure rule is unconstitutional as a violation of

the principles of free speech (opinion summarized in the July

2015 issue). The Center was given leave to file an amended

complaint, which gave rise to the October 31 decision.