The U.S. Court of Appeals for the Fifth Circuit (Fifth Circuit) has affirmed the Tax Court's denial of tax exemption under IRC Section 501(c)(4) for an accountable care organization, stating the organization was not operated with the exclusive purpose of promoting social welfare.

In Memorial Hermann Accountable Care Organization v. Commissioner, No. 23-60608, (5th Cir. October 28, 2024), the Fifth Circuit determined the Tax Court did not err in its determination that Memorial Hermann Accountable Care Organization (MHACO) did not operate exclusively for the promotion of social welfare under the "substantial nonexempt purpose" test.

Background

MHACO is a nonprofit corporation formed under Texas law, operating as an "accountable care organization" (ACO) in the Medicare Shared Saving Program (MSSP), which consists of groups of hospitals, physicians and other healthcare providers that work to manage and coordinate care for health plan beneficiaries. MHACO is controlled by Memorial Hermann Health System (Memorial Hermann), an IRC Section 501(c)(3) tax-exempt health care organization.

The Firth Circuit opinion states that, approximately 10% of MHACO's patients are part of the MSSP, an additional 9% are covered by Medicare Advantage Plans administered by commercial insurers, and the remaining 81% are covered by employer-sponsored health plans through commercial insurers. MHACO does not provide any services for people without insurance. While the portion of MHACO's revenue from MSSP varies by year, MHACO represented that 65% of its lifetime revenue came from MSSP activities.

MHACO applied for tax-exempt status as a social welfare organization, representing that it was "not organized for profit but operated exclusively for the promotion of social welfare" (emphasis added).¹ The IRS issued a proposed adverse determination letter in response to MHACO's exemption application. The IRS Office of Appeals, over MHACO's protest, issued a final adverse determination letter (202210023). The IRS determined that the ACO primarily benefited healthcare providers and insurance companies to which MHACO paid fees when those companies met cost and quality benchmarks, and therefore did not qualify for exemption under IRC Section 501(c)(4) (see Tax Alert 2022-0450).

MHACO appealed the IRS determination to the Tax Court, maintaining that it qualified as an organization described in IRC Section 501(c)(4) because it was operated primarily to promote the social welfare of its community.

The Tax Court upheld the IRS's determination, concluding that MHACO's "Non-MSSP activities primarily benefit its commercial payor and healthcare provider participants, rather than the public, and therefore constitute a substantial nonexempt purpose." (see Tax Alert 2023-0998). In doing so, the Tax Court found that a "substantial, non-exempt purpose" of MHACO was to benefit these private interests, so it was not "operated exclusively for social welfare" under IRC Section 501(c)(4). As authority for its decision, the Tax Court cited the "substantial non-exempt purpose" test set forth by the U.S. Supreme Court in Better Business Bureau of Washington, D.C. v. United States, 326 U.S. 279 (1945) for purposes of determining tax exemption qualification under IRC section 501(c)(3).

Analysis

The Fifth Circuit rejected MHACO's argument that the Tax Court used the wrong legal standard in determining whether the ACO qualifies as tax-exempt under IRC Section 501(c)(4). MHACO contended that, rather than using the IRC Section 501(c)(3) substantial non-exempt purpose test from Better Business Bureau, the Tax Court should have applied the "primary purpose test" under Treas. Reg. Section 1.501(c)(4)-1(a)(2)(i) for IRC Section 501(c)(4) social welfare organizations. This regulation provides that an organization is "operated exclusively for the promotion of social welfare if it is primarily engaged in promoting in some way the common good and general welfare of the people of the community." The regulation does not state that an organization does not qualify for IRC Section 501(c)(4) exemption if it serves a substantial non-exempt purpose.

The Fifth Circuit cited the U.S. Supreme Court's recent opinion in Loper Bright Enters. v. Raimondo, 144 S. Ct. 2244, 2273 (2024) in rejecting not only MHACO's argument but also the IRS's interpretation of the IRC Section 501(c)(4) "operated exclusively" standard in its regulations. The court noted that the phrase "operated exclusively" is used in both IRC Section 501(c)(3) ("operated exclusively for religious, charitable … or educational purposes") and IRC Section 501(c)(4) ("operated exclusively for the promotion of social welfare"), and stated that "it makes little sense to treat the same phrase differently in two neighboring paragraphs of the same statute." It noted that other circuits have relied on the Better Business Bureau substantial non-exempt purpose test to interpret "operated exclusively" not only for IRC Section 501(c)(3) purposes, but also for IRC Section 501(c)(4) purposes. Under that interpretation, "operating exclusively" means an organization cannot qualify for exemption under IRC Section 501(c)(4) if it has even a single non-exempt purpose that is substantial. In a footnote, the court added "in this particular case, applying either test — "substantial nonexempt" or "primary purpose" — would lead to the same result anyway."

The Fifth Circuit held that the Tax Court did not err in determining that MHACO does not qualify as an IRC Section 501(c)(4) organization. While acknowledging that many private enterprises have salutary effects on the greater community, the Fifth Circuit noted that MHACO offered its care coordination services only to people with health insurance, not the greater Houston community, and that "MHACO's members-only benefits system counsels against a conclusion that it is 'operated exclusively for the promotion of social welfare.'" The Fifth Circuit, like the Tax Court, did not analyze how or to what extent MHACO actually provided social welfare benefits to its community. Even if MHACO's services did benefit the greater community (which the Fifth Circuit said was not clear), the court determined that "the vast majority of [MHACO]'s operations pertain to creating cost savings that turn into revenue for insurance companies, private providers, and private payors." Further, the court did not find MHACO's control by Memorial Hermann, or Memorial Hermann's tax exemption or charitable operations, to be relevant to its analysis of MHACO's IRC Section 501(c)(4) qualification. The court's contrasted MHACO's private benefit to its members, payers and providers with its lack of social welfare promotion to the community as a whole: "In sum, MHACO does not assist the entirety of Houston given its lack of addressing uninsured people who lack Medicare." Accordingly, the Fifth Circuit concluded that MHACO did not qualify for exemption under IRC Section 501(c)(4).

Implications

The Fifth Circuit's decision in Memorial Hermann Accountable Care Organization v. Commissioner underscores the difficulty of ACOs being able to qualify for tax-exempt status under IRC Section 501(c)(4). Under the Fifth Circuit's and Tax Court's rationale, an ACO that provides services only to its members (rather than to its community as a whole), and benefits to its participating providers and payers, cannot qualify for IRC Section 501(c)(4) exemption unless it primarily serves MSSP patients and does not further a "substantial nonexempt purpose" of serving private interests (e.g., providers, payers, non-MSSP patients). Generally, the IRC Section 501(c)(3) exemption standard (i.e., organized and operated for charitable, educational, religious, etc. purposes) is considered more exacting than the IRC Section 501(c)(4) "operated exclusively for promotion of social welfare" exemption standard. Although MHACO did not request, and the Fifth Circuit did not rule on, IRC Section 501(c)(3) qualification, the court stated that the same substantial non-exempt purpose test applies for purposes of both IRC Section 501(c)(3) and 501(c)(4) exemption qualification. The Fifth Circuit noted, contrary to popular belief, that "the Treasury does not think that [IRC Section] 501(c)(4) is looser than [IRC Sections] 501(c)(3)." The Fifth Circuit did not expressly state its agreement with that position, but its opinion seemed to conflate the exemption standards in IRC Sections 501(c)(3) and 501(c)(4). Neither the Fifth Circuit nor the Tax Court distinguished the two standards, or explained how an ACO might promote social welfare in a way that would qualify for IRC Section 501(c)(4) exemption without being sufficiently charitable to qualify for IRC Section 501(c)(3) exemption.

Neither the Fifth Circuit nor the Tax Court define what constitutes "substantial," for purposes of determining whether an ACO furthers a substantial non-exempt purpose. The courts suggested they didn't need to do so because MHACO's non-exempt purpose was clearly substantial. The Fifth Circuit highlighted the magnitude of MHACO's commercial activities in benefitting private insurers and healthcare providers, stated that "MHACO's direct benefits accrue exclusively to its members," and suggested that any social benefit that MHACO may provide to the broader community in comparison to those private benefits is incidental. This suggests that substantial commercial activities can undermine an exempt organization's eligibility for IRC Section 501(c)(4) tax-exempt status, even if it engages in substantial tax-exempt social welfare activity.

Accordingly, an ACO that seeks tax exemption under IRC Section 501(c)(3) or IRC Section 501(c)(4) may face an uphill battle. It likely will need to establish to the IRS that a substantial majority of its members are MSSP patients and/or underserved persons in the community, that serving those persons promotes the social welfare of the community as a whole, and that any private benefit to members, providers, and payors is necessary and incidental to promoting the social welfare of the community.

The Fifth Circuit decision likely will affect not only ACOs, but also other nonprofit organizations seeking to qualify for IRC Section 501(c)(4) tax-exempt status. In affirming both the Tax Court's denial of MHACO's exemption application under IRC Section 501(c)(4) and the rationale for that denial, the Fifth Circuit blessed the IRS's narrow interpretation of the IRC Section 501(c)(4) exemption standard - that a "substantial non-exempt purpose" is fatal to IRC Section 501(c)(4) exemption qualification. The IRS likely will apply this narrower interpretation beyond the ACO context, in considering other applications for recognition of IRC Section 501(c)(4) exemption and in its examinations of IRC Section 501(c)(4) organizations.

Finally, the Fifth Circuit's decision is notable for being one of the first — if not the first — judicial decision(s) to apply the U.S. Supreme Court's Loper Bright ruling in not giving deference to applicable federal regulations applicable to tax-exempt organizations; in particular, the "primary purpose" standard for IRC Section 501(c)(4) exemption under Treas. Reg. Section 1.501(c)(4)-1(a)(2)(i). The Fifth Circuit noted that "we no longer are required to provide "Chevron deference" to the Treasury's interpretation of [IRC Section] 501(c)(4)," then boldly stated, "the IRS's embrace of a legal standard cannot supplant our independent interpretation of the statutory text." Ironically, in applying Loper Bright to affirm an IRS exemption denial, the court rejected the IRS's own primary purpose test. Future court opinions that apply Loper Bright probably will not be as friendly to the IRS.

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