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The IRS Clarifies How It Will Treat Tax-Exempt Hospitals Who Participate in Accountable Care Organizations ("ACOs")

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Gary J. McRay & Johanna M. Novak
Foster Swift Health Care Law E-News
December 7, 2011

The IRS issued Notice 2011-20 earlier this year in which it commented on how exempt organizations joining and participating in ACOs would be treated.  The Notice clarified two matters.

First, the IRS concluded that as a general matter, it would not consider a tax-exempt organization's participation in the Medicare Shared Savings Program ("MSSP") promulgated by the Patient Protection and Affordable Care Act ("PPACA") through an ACO to result in inurement or impermissible private benefit to the non-exempt ACO participants (i.e., the physicians and other health care providers) if certain safeguards were met.  For example, two of the safeguards include (i) the ACO be accepted into and continue in the MSSP, and (ii) any participation in the MSSP must also be set in advance in a writing negotiated at arm's length.

Secondly, the IRS stated that it expected that, absent any inurement or impermissible private benefit, any MSSP payments from the ACO (the shared cost savings with CMS) received by an exempt organization would be income not subject to unrelated business income tax ("UBIT") under Code Section 511 since such payments would be substantially related to the charitable purpose of "lessening the burdens of government."

The IRS then solicited comments from the public as to what additional guidance was needed to facilitate participation by tax-exempt organizations in the MSSP through ACOs.

On October 20, 2011, the IRS issued a new Fact Sheet (FS-2011-11) that provided additional information for exempt organizations on how their participation in the MSSP through an ACO would be treated by the IRS.  The following was clarified in the Fact Sheet.

  1. CMS and the IRS have no specific requirement of the type of legal entity for an ACO, other than that it must be separate from its participants, except for clinically integrated organizations (i.e., a hospital with employed physicians).  An ACO structured as a corporation for federal tax purposes will be treated as a separate taxable entity from its participants.  See Q.4 of the Fact Sheet.  The Service makes it clear than an ACO engaged exclusively in the MSSP could qualify for a federal tax exemption under Code Section 501(c)(3), as long as the ACO met all of the other requirements for a federal tax exemption.  See Q.16.  However, since many ACOs plan to expand beyond Medicare, it may be too restrictive to obtain a tax exemption at the ACO level.
  2. If an ACO is structured as a partnership for federal tax purposes, its activities will generally be attributed to its partners.  A limited liability company will be treated as a partnership unless it chooses to be treated as a corporation or as a partnership that is disregarded for tax purposes.  The IRS did clarify that the tax-exempt hospital in an ACO treated as a partnership would not have to have majority control over the ACO in order to insure that its participation in the ACO furthers a charitable purpose.  See Q.9.  The IRS believes that the CMS's regulation and oversight of the ACO will be sufficient to ensure that the ACO's participation in the MSSP will further the charitable purpose of lessening the burdens of government.  However, if the ACO goes beyond participating in the MSSP into non-MSSP business or purposes, then one must review all of the IRS guidance regarding joint ventures, including the IRS preference that the exempt organization have control over the joint venture activity to insure the hospital's exemption is still protected.
  3. Some non-MSSP activities may further a charitable purpose.  For example, an ACO activity related to serving Medicaid or indigent populations might further the charitable purpose of relieving the poor and distressed or underprivileged.  Q.12.  Not all activities that promote health further charitable purposes.  However, the IRS makes it clear that participants' tax-exempt status will not be jeopardized if the ACO's non-charitable activities, including commercial insurance activities, would be no more than an insubstantial amount of the ACO's total activities.  See Q.14.
  4. The charitable organization does not always have to satisfy all five safeguard factors described in Notice 2011-20 to avoid inurement or impermissible private benefit.  Whether an exempt organization's participation with an ACO creates a problem for its tax exemption will depend on all the facts and circumstances.  The IRS makes it clear that all five factors are important, but no particular factor must be satisfied in all circumstances to prevent inurement or impermissible private benefit.  See Q.18.  The IRS also made it clear that the ownership interests in the ACO do not always have to be directly proportional to capital contributions and the ACO does not always have to distribute shared savings payments in proportion to such ownership interests.  It may be that the typical ACO causes the exempt organization to receive an ownership interest in the ACO that is proportional and equal in value to its capital contribution and that the allocations and distributions are made in proportion to ownership interests.  However, the IRS is willing to take into account all of the contributions made by the other ACO participants to the ACO, including cash, property and services and all economic benefits received by the ACO participants in determining whether the parties are treated fairly and that there is no inurement or impermissible benefit flowing to the physicians and other non-tax exempt organizations.
  5. And, finally, the IRS confirmed that it is continuing to follow a May 2007 memorandum from the Director of Exempt Organizations, which stated that the IRS will not treat the EHR benefits that a hospital provides to its medical staff physicians as inurement or impermissible private benefit if: (i) the benefits are all within the range of EHR software and technical support services that are permissible under certain U.S. Department of Health & Human Services regulations, and (ii) the hospital meets certain other specified requirements of the memorandum.

The hospital industry appreciates the additional guidance from the IRS.  For many hospitals, the two most obvious ACO legal entities will be: (i) non-profit but taxable PHO corporations, which have as shareholders the exempt organization, or (ii) non-exempt providers or LLCs that are treated as tax partnerships, which will have as members the exempt hospital and the other physician providers and non-exempt entities.  The IRS has demonstrated that it will be more flexible when reviewing ACO legal structures than it has been in the past when reviewing the typical joint venture between a hospital and its medical staff members.