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November 14, 2017

Organization's lease of hospital to for-profit results in loss of tax-exemption

In PLR 201744019, the IRS revoked the tax-exempt status of a Section 501(c)(3) organization that had ceased to operate a hospital and instead was leasing the hospital to a for-profit entity under terms that gave the for-profit entity control over the management and operation of the hospital. The IRS concluded that the Section 501(c)(3) organization had not retained any enforceable control of charitable activities, despite a provision in the lease agreement stating that the for-profit entity would provide charity care.


Although some important facts are redacted from the revocation letter, it involves a general acute care hospital located in a rural community. The organization originally operating the hospital (ORG) had applied for, and received, recognition as a tax-exempt organization under Section 501(c)(3). Due to financial difficulties, however, ORG transferred control of the hospital at some point in time to the community.

A community board assumed governance of ORG and took over responsibility for operation of the hospital. ORG eventually transferred management and operational control over the hospital to a for-profit entity. ORG leased the hospital land, property and equipment to the for-profit entity, and turned over control of all hospital operations to it, including collection of revenues. As part of the lease, the for-profit entity agreed to continue to provide charity care consistent with the past practices of the hospital. ORG, however, ceded complete control over operations to the for-profit entity.

Through its all-volunteer community board, ORG notified the IRS of its change in activities through all of its subsequently filed Forms 990. Its program service accomplishment was listed as operation of a hospital leased to a for-profit entity to accomplish the stated goal of providing medical care in its rural community. However, ORG did not otherwise formally notify the IRS of the change in activities, nor did it seek to obtain an affirmation letter or private letter ruling to confirm that it continued to qualify for tax-exempt status.


Serving a rural community

The IRS stated that there is some argument that ORG has continued to serve exempt purposes by leasing the hospital to the for-profit entity to ensure continued availability of medical care in a rural community. Citing Revenue Rulings 73-313 and 80-309, the IRS noted that such activities may be considered to constitute exempt purposes under certain circumstances.

In Revenue Ruling 73-313, the IRS ruled as exempt under Section 501(c)(3) an organization formed and supported by residents of an isolated rural community to provide medical facilities at reasonable rent to attract a doctor to provide medical services to the entire community. In Revenue Ruling 80-309, the IRS ruled that a nonprofit organization that was created to construct, maintain and operate or lease a public hospital for the benefit of the surrounding community was operated exclusively for charitable purposes.

In the immediate ruling, however, the IRS concluded that ORG did not provide sufficient evidence to establish an exempt purpose related to providing medical care to an underserved rural community. It stated that ORG provided little information to show that its arrangement and circumstances were akin to those of the organization in Revenue Ruling 73-313. For example, ORG failed to establish that the manner in which it devoted resources to the provision of a physical facility for medical practice qualifies as a charitable use. It did not establish that the lease arrangement with the for-profit entity bore a reasonable relationship to the promotion and protection of the health of the community. The IRS also determined that ORG's arrangement was unlike the one in Revenue Ruling 80-309, which involved leasing to a non-profit operator, rather than a for-profit entity as in ORG's case.

Control over operations

The IRS stated that the "overriding factor" in rulings with respect to whether a hospital functions in an exempt manner is the control over the operation and the ability to ensure it will be operated for exempt purposes. In this respect, the IRS cited Revenue Rulings 69-545 and 98-15.

Revenue Ruling 69-545 compared the characteristics of two hospitals (one ruled exempt, one non-exempt):

1. Exempt hospital: controlled by a board of trustees composed of independent civic leaders; maintains an open medical staff; operates a full-time emergency room open to all regardless of ability to pay and otherwise admits all patients able to pay; and uses surplus funds to improve the quality of patient care, expand facilities and advance its medical training, education and research programs

2. Non-exempt hospital: controlled by physicians who have a substantial economic interest in the hospital; restricts the number of physicians admitted to the medical staff; enters into favorable rental agreements with individuals who control the hospital; and limits emergency room and hospital admission substantially to the patients of the physicians who control the hospital

While the IRS acknowledged that ORG was not exactly like the first or second hospital in Revenue Ruling 69-545, it concluded that it was much more like the second, non-exempt hospital. The IRS stated that ORG has not demonstrated that it has any control over the operations of the for-profit entity to which it leases the hospital. While the lease does contain a provision about providing charity care, it does not provide any means for ORG to enforce the provision. Without such controls, the IRS stated that a hospital operated by a for-profit entity will be focused on the "bottom line, not the welfare of the general public."

The IRS also determined that ORG "comes nowhere close to qualifying" under the standard for joint ventures between a for-profit and a non-profit to establish exempt function. Citing Revenue Ruling 98-15, the IRS explained that, to qualify under the standard, the tax-exempt entity must maintain control of the joint venture. The IRS stated that the lease requirements of maintenance of an acute care hospital and a charity care policy "were not nearly enough" to constitute operating for a Section 501(c)(3) purpose and that an exempt hospital's "entire focus must be on community welfare." This was defined as "determining the health needs of the community and enacting educational and other programs designed to both prevent and address community health problems." The IRS went on to note that "[t]hese are typically the types of activities that for-profit healthcare providers do not involve themselves in because they are a drain on the entity's financial resources." Control of the hospital by a for-profit entity guarantees that there would be a focus on the bottom line and not the welfare of the general public. In the event of a conflict between operation in accordance with the community benefit standard and the duty to maximize profits, the for-profit entity would be free to give deference to profit maximization.

Revenue Ruling 98-15 does provide that a Section 501(c)(3) organization may enter into a management agreement that gives a private party the authority to conduct activities on behalf of the tax-exempt organization and use its assets. However, this is conditional; the tax-exempt organization must retain ultimate authority over the assets and activities that are being managed. In this situation, the IRS found that ORG did not have control sufficient to ensure the hospital would be operated for exempt purposes. ORG ceded operational control and the charity care provision in the lease was insufficient: (1) because there was no apparent way for ORG to enforce it; and (2) exempt operations would require more than just a charity care policy. Also, ORG had no way to ensure that charity care was occurring because it did not have access to the for-profit entity's books and records.


The IRS ruled that ORG failed the operational test for qualifying for exemption under Section 501(c)(3), because it allowed a for-profit to have complete control over its hospital operations. ORG did not exercise adequate discretion and control as required by Section 501(c)(3).


In this revocation ruling, the IRS emphasized that the tax-exempt organization's control over a hospital's activities is essential to meet the operational test of Section 501(c)(3) and that there must be a clear mechanism for enforcing charitable provisions in agreements with for-profit entities. Tax-exempt organizations that utilize for-profit entities to manage or operate their facilities should ensure that their agreements clearly document how the tax-exempt entity can ensure that the operations are consistent with exempt purposes and that there is an enforcement mechanism. The agreements should provide broadly that exempt purposes will be followed, not just that a charity care policy will be maintained.

In addition, hospitals and other healthcare providers that rely for exemption upon IRS rulings regarding underserved areas, such as rural communities, should be prepared to provide clear, substantial and convincing evidence that they fit within the rationale of those rulings, because the IRS narrowly applied them in this particular situation.

Please contact your Ernst & Young LLP professional for further information.


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Contact Information
For additional information concerning this Alert, please contact:
Tax-Exempt Organizations Group
Mike Vecchioni(313) 628-7455;
Justin Lowe(202) 327-7392;
Mike Payne(602) 322-3620;
John Rigney(314) 290-1106;


Other Contacts
Exempt Organizations Tax Services Markets and Region Leadership
Scott Donaldson, Americas Director – Phoenix(602) 322-3062;
Mark Rountree, Americas Markets Leader and Health Sector Tax Leader – Dallas(214) 969-8607;
Bob Lammey, Northeast Region and Higher Education Sector Leader – Boston (617) 375-1433;
Bob Vuillemot, Central Region – Pittsburgh(412) 644-5313;
John Crawford, Central Region – Chicago(312) 879-3655;
Debra Heiskala, West Region – San Diego(858) 535-7355;
Joyce Hellums, Southwest Region – Austin(512) 473-3413;
Kathy Pitts, Southeast Region – Birmingham(205) 254-1608;