REDLANDS SURGICAL SERVICES v. Commissioner

113 T.C. No. 3UNITED STATES TAX COURT
REDLANDS SURGICAL SERVICES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 11025-97X. Filed July 19, 1999.
P is a nonprofit corporation. Its sole activity
is participating as co-general partner with a for-
profit corporation in a partnership that is general
partner of an operating partnership that owns and
operates an ambulatory surgery center. Held: On the
facts involved herein, P has ceded effective control
over the operations of the partnerships and the surgery
center to private parties, conferring impermissible
private benefit. P is therefore not operated
exclusively for exempt purposes within the meaning of
sec. 501(c)(3), I.R.C. 1986.
James L. Malone III and Robert C. Louthian III, for
petitioner.
Joan Ronder Domike and Elizabeth Purcell, for respondent.
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THORNTON, Judge: Petitioner brought this action for a
declaratory judgment, pursuant to section 7428 and Title XXI of
this Court's Rules. Petitioner requests the Court determine the
correctness of respondent’s adverse determination with respect to
its initial qualification as a tax-exempt organization under
section 501(c)(3).1 The parties have submitted this case fully
stipulated under Rule 122 on the basis of the pleadings and the
stipulated administrative record, which is incorporated herein by
this reference.
FINDINGS OF FACT
Petitioner is a California nonprofit public benefit
corporation with its principal place of business in Redlands,
California. It is a wholly owned subsidiary of Redlands Health
Systems, Inc. (RHS), a California nonprofit public benefit
corporation that has been recognized as exempt under section
501(c)(3) of the Code and as a public charity within the meaning
of section 509(a). RHS is the parent corporation of three
subsidiaries in addition to petitioner, namely Redlands Community
Hospital (Redlands Hospital) and Redlands Community Hospital
Foundation (Redlands Foundation), both of which are California
nonprofit public benefit corporations that have been recognized
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code as in effect for the time period
referred to. All Rule references are to the Tax Court Rules of
Practice and Procedure.
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as exempt under section 501(c)(3); and Redlands Health Services,
a for-profit corporation.
As described in more detail below, and as reflected
schematically in the appendix hereto, in 1990 RHS became co-
general partner with a for-profit corporation, Redlands-SCA
Surgery Centers, Inc. (SCA Centers), in a general partnership
formed to acquire a 61-percent interest in an existing outpatient
surgical center in Redlands, California, two blocks from the
Redlands Hospital facility. This general partnership in turn
became sole general partner in the California limited partnership
that owns and operates the surgical center. Under a long-term
management contract, SCA Management Co. (SCA Management)--a for-
profit affiliate of SCA Centers--manages the day-to-day
operations of the surgical center, in return for a percentage of
gross revenues. Several months after forming the general
partnership, RHS formed petitioner to succeed to its interest in
it.
Petitioner has no activity other than its involvement with
the partnerships. The question is whether petitioner is operated
exclusively for exempt purposes within the meaning of section
501(c)(3). We hold that it is not.
Redlands Hospital
Since its founding in 1929, Redlands Hospital has been
recognized by respondent as a charitable organization described
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in section 501(c)(3) and as a "hospital" described in section
170(b)(1)(A)(iii). Its mission includes providing necessary
medical care free of charge, or at a discount, to individuals
without insurance or other means of paying.
Redlands Hospital has its own outpatient surgery program
within the hospital facility. It also maintains a 24-hour
emergency room that provides emergency medical services for all
patients regardless of their ability to pay. It maintains an
open medical staff and is governed by a community-based board of
directors. It does not discriminate on the basis of race,
gender, age, color, national origin, or disability.
Inland Surgery Center, L.P.
Since its inception in 1983, the Inland Surgery Center
Limited Partnership (the Operating Partnership) has operated a
freestanding ambulatory surgery center (the Surgery Center) in a
12,000-square foot building within two blocks of Redlands
Hospital. During the 1980's, the Operating Partnership was a
successful for-profit venture, serving only surgical patients who
were able to pay, by insurance or otherwise. Prior to its
affiliation with the General Partnership, the Operating
Partnership comprised Beaver Medical Clinic, Inc., and some 30
physician partners, who were also physicians on the medical staff
of Redlands Hospital.
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The Affiliation of Redlands Hospital With the Surgery Center
Before 1990, Redlands Hospital desired to increase its
outpatient surgery capacity but lacked the capital resources and
experience to develop and operate its own freestanding outpatient
facility. In addition, such a facility would have been in
competition with the existing Surgery Center, and there was
concern that the Redlands community could not sustain both.
On March 1, 1990, RHS and SCA Centers entered into a
general partnership agreement to acquire jointly a 61-percent
general partnership interest in the Surgery Center.2 The
partnership is known as Redlands Ambulatory Surgery Center (the
General Partnership).
SCA Centers is a for-profit, wholly owned subsidiary of
Surgical Care Affiliates, Inc. (SCA), a publicly held corporation
based in Nashville, Tennessee, and specializing in owning and
managing ambulatory surgery centers.3 Prior to formation of the
General Partnership, neither SCA nor any of its affiliated
entities had any relationship, contractual or otherwise, with RHS
or any of its affiliated entities, or with the Surgery Center.
2
Redlands Hospital is also a signatory to the general
partnership agreement but only with respect to secs. 16 and 17 of
that agreement (regarding noncompetition and affiliated status).
3
As of 1995, SCA owned, in whole or part, and operated
approximately 40 ambulatory surgery centers throughout the United
States, some of which were owned in part by tax-exempt health
care systems.
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RHS contributed $1,131,289 to the General Partnership,
borrowing $796,829 from SCA and the balance of $334,460 from
Redlands Hospital. SCA Centers contributed $1,946,993 in cash
and stock to the General Partnership. In return for its
approximately 37-percent capital investment, RHS received a 46-
percent interest in profits, losses, and cash-flows of the
General Partnership. In return for its approximately 63-percent
capital investment, SCA Centers received a 54-percent interest in
profits, losses, and cash-flows of the General Partnership.
The General Partnership agreement provides in relevant part:
AGREEMENT OF GENERAL PARTNERSHIP
OF REDLANDS AMBULATORY SURGERY CENTER
This AGREEMENT OF GENERAL PARTNERSHIP, [is] entered into as
of the 1st day of March, 1990, by and between REDLANDS-SCA
SURGERY CENTERS, INC., a California corporation ("SCA
Centers") and a wholly owned subsidiary of Surgical Care
Affiliates, Inc. ("SCA") * * *, RHS Corp., ("RHS") a
California not-for-profit corporation, * * * and Redlands
Community Hospital, a California not-for-profit corporation
(the "Hospital"). SCA Centers and RHS are collectively
referred to as "Partners."
WITNESSETH:
WHEREAS, RHS desires to insure the
availability of high quality health services
in the most cost effective setting in which
such services can be rendered; and
WHEREAS, the use of an ambulatory surgical
center by the area-wide residents will
contribute to RHS's corporate goal of
providing comprehensive health care services
at an affordable price; and
WHEREAS, SCA is a corporation that is engaged
in the development and management of
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ambulatory surgical centers and has the
expertise necessary to operate ambulatory
surgical centers; and
WHEREAS, RHS and SCA Centers desire to enter
into a Partnership to be equally controlled
by representatives of the Partners.
NOW, THEREFORE, in consideration of the
mutual covenants herein contained, SCA
Centers and RHS agree to be partners in a
general partnership (the "Partnership")
pursuant to the California Uniform
Partnership Act (the "Act") on the terms and
conditions hereinafter set forth.
1. Name and Purpose.
(a) The Partnership shall be carried on
under the name of Redlands Ambulatory
Surgery Center or such other name as may
be selected by the Managing Directors.
The Partnership has been formed to
acquire a 61 percent general partner
interest (the "General Partner
Interest") in a California limited
partnership (the "Operating
Partnership") which owns and operates a
freestanding ambulatory surgery center
in Redlands, California known as the
Inland Surgery Center (the "Center").
The Partnership may engage in any and
all other activities as may be
necessary, incidental or convenient to
carry out the business of the
Partnership as contemplated by this
Agreement.
* * * * * * *
3. Term. The Partnership shall commence on April 30,
1990, or such later date as the Partners shall
mutually agree, and shall continue until March 31,
2020, or such other date as the partners shall
mutual [sic] agree.
4. Management.
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(a) General Management by the Managing Directors.
The general management and determination of all
questions relating to the affairs and policies of
the Partnership, except for questions relating to
the medical standards and medical policies of the
centers, shall be decided by a majority vote of
the Managing Directors. The Managing Directors
shall consist of four (4) persons, two (2) of whom
shall be chosen by SCA Centers and two (2) of whom
shall be chosen by RHS. Notwithstanding the
above, it is recognized that the Managing
Directors have no authority to amend the
Partnership Agreement. In the event the Managing
Directors are unable to agree on a matter, either
Partner may institute the following arbitration
procedure to resolve the matter. Within three (3)
days of a Partner's notifying the other of
institution of this arbitration procedure, each
Partner shall select an arbitrator to resolve the
matter. Within seven (7) days after the selection
of the arbitrators, those arbitrators shall select
a third. Within five (5) days after selection of
the third arbitrator, each Partner shall submit in
writing to each of the arbitrators the Partner's
position on the matter to be resolved. The
arbitrators shall decide the matter and advise the
Partners in writing of their decision within
fourteen (14) days after the Partners' submission
of their written positions. In hearing such
arbitration the arbitrators shall determine the
procedural rules to be applied and shall apply the
substantive law of the State of California without
regard to conflict of law considerations. The
decision of a majority of the arbitrators shall be
final and binding. The costs and expenses of the
arbitrators shall be divided equally between the
Partners.
(b) Medical Advisory Group. The
determination of all questions relating
to the medical standards and medical
policies of the center shall rest with
the Medical Advisory Group. The
determination as to what constitutes a
medical decision, standard or policy
shall rest with the Managing Directors.
The Managing Directors shall select 50
percent of the Medical Advisory Group.
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(c) Operating Partnership Agreement and
Purchase Agreement. RHS hereby
authorizes SCA Centers to execute on
behalf of the Partnership: (i) the
Operating Partnership's Partnership
Agreement; (ii) an agreement to acquire
the General Partner Interest (the
"Purchase Agreement"); and (iii) all
exhibits to the Purchase Agreement.
* * * * * * *
12. Management Agreement. The Operating
Partnership shall enter into a Management
Agreement with SCA Management Company, a
wholly-owned subsidiary of SCA ("Management")
whereby Management assumes full
responsibility for administering the day-to-
day operation of the ambulatory center in
accordance with the goals, policies and
objectives of the Operating Partnership. The
Agreement will be for a term of fifteen (15)
years with two (2) five (5) year extensions
at Management's sole discretion and will
provide Management with a fee equal to Six
Percent (6%) of the Operating Partnership's
gross revenues. Legal, accounting, travel,
lodging, meals and other such professional
services associated with the management and
administration of the ambulatory surgery
center shall be reimbursed to Management.
13. Quality Assurance Agreement. Management
shall enter into an [sic] Quality Assurance
Agreement with RHS whereby RHS will agree to
perform certain managerial and supervisory
quality assurance duties in connection with
the operation of the Center. The Quality
Assurance Agreement will continue from year
to year unless terminated by either of the
parties thereto. RHS will receive no fee
under the Quality Assurance Agreement during
the first year thereof and thereafter will be
paid a fee equal to one percent of gross
revenues as defined in such Agreement,
payable monthly.
* * * * * * *
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16. Non-Compete. The Partners and RHS
hereby agree that during the term of this
Partnership, and for two years thereafter,
neither party, nor an affiliate of either
party, shall participate in the ownership,
management or development of a free-standing
surgical center which is within those
portions of San Bernardino and Riverside
Counties falling within a twenty (20) miles
radius of the Center unless authorization is
obtained from the other party. Further, the
Hospital shall not expand or promote its
present outpatient surgery program within the
Hospital. Notwithstanding the foregoing in
the event that either Partner acquires the
entire interest of the other Partner herein,
this Section 16 shall not apply thereafter to
the purchasing Partner or its affiliates.
17. Affiliated Status. To the extent
legally permissible, the Hospital agrees to
recognize the surgery center as an affiliate
for managed care contracting purposes (i.e.,
HMOs and PPOs).
18. New Services and Procedures.
(a) Exhibit B lists medical services
and procedures currently available at
the Center and those which the Partners
expect to be performed there in the near
future. SCA Centers acknowledges that
(1) RHS is an affiliate of the Hospital,
and (2) that the Hospital enjoys a
valuable reputation in the area for
providing quality medical care to
patients, (3) that the Hospital's
association with the Center through
RHS's participation in this Partnership
will benefit the Center and (4) that RHS
has an important interest in ensuring
that services and procedures performed
at the Center, or by an entity with
which RHS is associated by virtue of
this Partnership, within the Hospital's
service area are only such services and
procedures which are recognized by a
majority of the medical community as
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being safely and efficaciously performed
in a non-hospital, outpatient setting.
(b) Unless otherwise approved by the
Managing Directors (whose actions in
matters under this Paragraph shall be
final and not subject to arbitration or
review, even if deadlocked), no
procedures or services currently
available to patients in the State of
California which are not listed on
Exhibit B shall be performed at the
Center (or by RHS, SCA or the Center
limited partnership, or an affiliate of
any of them, excluding the Hospital),
within the area set forth in Paragraph
16, unless and until such procedures or
services are performed or available on a
non-hospital, outpatient basis at a
majority of the free-standing outpatient
surgery facilities in Imperial, Kern,
Los Angeles, Orange, Riverside, San
Bernardino, San Diego and Ventura
Counties.
(c) With respect to new services or
procedures which first become available
in California during the term hereof,
such services or procedures shall not be
performed by RHS, SCA, the Center
limited partnership or an affiliate of
any of them in the area identified above
until the Managing Directors determine,
based on reliable medical evidence
and/or testimony, that such services and
procedures can be safely and
efficaciously performed on a non-
hospital, outpatient basis.
* * * * * * *
23. Assignment. Each Partner shall have the
right, without the prior approval of the
other and without triggering the provisions
of paragraph 14 hereof, to transfer or assign
all or any part of its interest in this
Partnership to an affiliated entity; * * *
in the event either Partner assigns its
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interest hereunder the provisions of Section
16, shall continue to apply to the assignor,
as well as to the assignee, and the interest
held by the assignee shall be subject to
repurchase as provided in Section 19 hereof,
upon the breach of Section 16 by the
assignor, the assignee [or] their Affiliates.
The General Partnership’s Acquisition of the Operating
Partnership Interest
Effective April 30, 1990, the General Partnership entered
into an amended and restated agreement of the Operating
Partnership in accordance with the Revised Limited Partnership
Act of the State of California. Pursuant to this agreement, the
General Partnership acquired, for approximately $3 million, a 61-
percent general partnership interest in the Operating
Partnership.4 As part of the purchase price, the General
Partnership agreed to contribute $1,598,495 by delivering to the
limited partners (with the exception of Beaver Medical Clinic)
shares of SCA common stock with an equivalent market value.5
4
Prior to Apr. 30, 1990, the three general partners of the
Operating Partnership were two individuals who had aggregate
ownership interests of 24 percent, and Beaver Medical Clinic,
Inc., which had a 6-percent ownership interest. Effective Apr.
30, 1990, the two individual general partners sold their
aggregate 24-percent interests, and Beaver Medical Clinic, Inc.
converted its 6-percent general partner interest into a 10.3-
percent limited partner interest. The other limited partners are
physicians who are also on the medical staff of Redlands
Hospital.
5
The General Partnership subsequently reduced its ownership
interest in the Operating Partnership to 59 percent as a result
of the sale of 2 percent of the general partner interest to a
(continued...)
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To determine the General Partnership’s investment, the
Operating Partnership was valued at four to five times earnings.
No formal appraisal was acquired; rather, the valuation was
determined based on SCA’s experience and knowledge of the market
and by a review of historical records. An unrelated bidder (a
for-profit company, not otherwise identified in the record) was
offering the Operating Partnership a higher purchase price based
on approximately six times earnings. The existing partners of
the Operating Partnership agreed to the offer made by the General
Partnership due to the desire to have an affiliation with
Redlands Hospital for quality control review and other reasons,
such as to supervise the teaching and maintenance of up-to-date
surgery methodologies.
The General Partnership is the sole general partner of the
Operating Partnership. There are 32 limited partners. Except
for Beaver Medical Clinic, Inc., the limited partners are all
physicians who are also on the medical staff of Redlands
Hospital. Two of the limited partners are board members of
Redlands Hospital and RHS. The amended Operating Partnership
agreement contains no statement of charitable purpose and imposes
no requirement that the Operating Partnership operate for a
5
(...continued)
physician, with that interest then being converted to a limited
partner interest. The limited partners currently have a 41-
percent interest in the Operating Partnership.
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charitable purpose. Relevant portions of the amended Operating
Partnership agreement are set out below:
AMENDED AND RESTATED CERTIFICATE AND AGREEMENT
OF LIMITED PARTNERSHIP
OF INLAND SURGERY CENTER, L.P.
* * * * * * *
IV. BUSINESS
The business of the Partnership is to own and operate
the Center and to carry on any and all activities necessary,
proper, convenient, or advisable in connection therewith.
* * * * * * *
VI. CAPITAL CONTRIBUTION, STATUS AND
ADDITIONAL WORKING CAPITAL
6.1 Capital Contribution of the General Partner. Upon
execution of this Agreement, the General Partner will
contribute $1,979,077 to the Partnership to be paid
$1,655,842 by check or by wire transfer and $1,598,495 by
delivering Shares,[6] which shall be simultaneously
distributed to the Limited Partners, other than [Beaver
Medical Clinic], in the amounts set forth on Schedule C.
For purposes of payment of the contribution, the Shares
shall be valued at the average of the closing prices of the
Shares, as reported by the NASDAQ National Market System, on
each of the five trading days which are prior to the ten
business days prior to April 30, 1990.
* * * * * * *
SCA will also make available to each Limited
Partner, other than [Beaver Medical Clinic], appropriate
officers of SCA who will respond to questions relating to
the material furnished and the business and affairs of SCA.
The Limited Partners who receive such shares shall
not sell, exchange, pledge hypothecate or otherwise dispose
6
Paragraph 1.25 of the Operating Partnership agreement
defines “Shares” as “$.01 par value common stock of SCA”.
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of the shares prior to the date six months have elapsed from
the date this Agreement is executed. In any transfer of the
Shares, the Limited Partners shall comply with the
prospectus delivery requirements of the Securities Act of
1933.
* * * * * * *
7.3 Management Fees. SCA Management Company, a
subsidiary of SCA, will enter into a Management Agreement
with the Partnership pursuant to which SCA Management
Company will provide management, purchasing and other
services and support to the Partnership. SCA Management
Company will be reimbursed for any direct costs incurred in
managing the Partnership and will be paid an annual
management fee equal to 6% of the Partnership’s Gross
Revenues payable monthly.
VIII. ALLOCATION OF INCOME AND LOSS: CASH DISTRIBUTIONS
8.1 Available Cash Flow. The Partnership shall
distribute Available Cash Flow and any other property
received by the Partnership as a result of the operations of
the Center or sale of its assets (a) 1.1366% to the holder
of each outstanding Unit,(b) 10.3% to [Beaver Medical
Clinic] and (c) the balance to the General Partner.
* * * * * * *
8.4 Profits and Losses. Profits and losses shall
be allocated 10.3% to [Beaver Medical Clinic], 1.1366% to
the holder of each Unit and the balance to the General
Partner. * * *
* * * * * * *
IX. RIGHTS, POWERS AND OBLIGATIONS OF THE GENERAL PARTNER
9.1 Powers. The management and control of the
Partnership and its business and affairs shall rest
exclusively with the General Partner, which shall have all
the rights and powers which may be possessed by a general
partner pursuant to the Act, and such additional rights and
powers as are otherwise conferred by law or are necessary,
advisable or convenient to the discharge of its duties under
this Agreement. The General Partner shall be the “tax
matters partner” within the meaning of the Code. Without
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limiting the generality of the foregoing, the General
Partner may, at the cost, expense and risk of the
Partnership:
9.1.1. Spend the capital and net income of
the Partnership in the exercise of any rights or
powers possessed by the General Partner hereunder;
9.1.2. Lease the Land, manage and operate
the Center and enter into agreements containing
such terms, provisions and conditions as the
General Partner in its discretion shall approve;
9.1.3. Purchase from or through others
contracts of liability, casualty and other
insurance which the General Partner deems
advisable for the protection of the Partnership or
for any purpose convenient or beneficial to the
Partnership;
9.1.4. Incur indebtedness in the ordinary
course of business;
9.1.5. Subject to the provisions of Section
9.4.1.2 of this Agreement, sell or otherwise
dispose of, upon such terms and conditions as the
General Partner may deem advisable, appropriate or
convenient, any of the assets of the Partnership;
9.1.6. Invest in short-term debt obligations
(including obligations of federal and state
governments and their agencies, commercial paper
and certificates of deposit of commercial banks,
savings banks or savings and loan associations)
and “money market” mutual funds, such funds as are
temporarily not required for the purposes of the
Partnership’s operations; and
9.1.7. Delegate all or any of its duties
hereunder and, in furtherance of any such
delegation, appoint, employ, or contract with any
person (including affiliates of the General
Partner) for the transaction of the business of
the Partnership, which persons may, under the
supervision of the General Partner, act as
consultants, accountants, attorneys, brokers,
escrow agents, or in any other capacity deemed by
the General Partner necessary or desirable, and
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pay appropriate fees to any of such persons;
provided, however, the General Partner shall not
delegate duties hereunder which are required to be
performed by SCA Management Company under the
Management Agreement.
9.2. Independent Activities. Subject to the
provisions of Section 16.2 of this Agreement, the General
Partner and each Limited Partner may, notwithstanding the
existence of this Agreement, engage in whatever activities
they choose, whether or not the same be competitive with the
Partnership, without having or incurring any obligation to
offer any interest in such activities to the Partnership or
any party hereto, and, as a material part of the
consideration for the General Partner’s execution hereof and
for the admission of such Limited Partner, each Limited
Partner hereby waives, relinquishes and renounces any such
right or claim of participation.
9.3. Duties. The General Partner shall manage and
control the Partnership, its business and affairs to the
best of its ability and shall use its best efforts to carry
out the business of the Partnership. The General Partner
shall devote itself to the business of the Partnership to
the extent that it, in its discretion, deems necessary for
the efficient carrying on thereof. The General Partner
shall act as a fiduciary with respect to the safekeeping and
use of the funds and assets of the Partnership.
9.4. Certain Limitations.
9.4.1 Without obtaining the consent of all
of the Partners, the General Partner shall not:
9.4.1.1. Act in contravention of this
Agreement;
9.4.1.2. Except as provided in Article XII
of this Agreement, do any act which would make it
impossible to carry on the ordinary business of
the Partnership;
9.4.1.3. Confess a judgment against the
Partnership;
9.4.1.4. Assign the Partnership property in
trust for creditors or on the assignee’s promise
to pay the debts of the Partnership;
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9.4.1.5. Submit a Partnership claim or
liability to arbitration or reference; or
9.4.1.6. Dispose of the goodwill of the
Partnership.
* * * * * * *
9.6. Medical Advisory Group. The Partnership shall
have a Medical Advisory Group consisting of six Limited
Partners appointed annually. Three members of the Medical
Advisory Group shall be appointed by [Beaver Medical
Clinic]. The three remaining members shall be appointed by
the General Partner. Vacancies in the Medical Advisory
Group shall be filled in accordance with the above
procedure. Subject to law regulations, and the standards of
applicable regulatory bodies, the medical standards of the
Partnership will be under the control of the Medical
Advisory Group. The General Partner will determine what are
medical standards and policies.
* * * * * * *
10.4 Government Regulation. In the event that, in the
opinion of counsel to the Partnership, the referral of
Medicare or any other patients to the Center by Partners
becomes illegal, the Partnership shall require each Limited
Partner to offer his interest to the General Partner for
five times the reportable taxable income allocated to that
interest on the Partnership Return for the tax year
immediately preceding the year in which counsel determines
such reference is illegal. Up to 50% of the purchase price
shall, at the option of the General Partner, be paid in
unregistered Shares. The General Partner shall have 30 days
in which to accept such offer.
* * * * * * *
XV. LIABILITY OF THE GENERAL PARTNER
15.1. Return of Capital Contribution. Anything in
this Agreement to the contrary notwithstanding, the General
Partner shall not be individually liable for the return of
the Capital Contributions of the Limited Partners, or any
portion thereof, it being expressly understood that any such
return shall be made solely from Partnership assets.
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15.2. Exculpation and Indemnification. The doing of
any act or the failure to do any act by the General Partner
shall not subject the General Partner to any liability to
the Partnership or the Partners, except for gross negligence
or willful malfeasance. The Partnership shall indemnify the
General Partner against losses sustained in connection with
the Partnership, provided that the losses were not the
result of gross negligence, self-dealing or willful
malfeasance on the part of the General Partner.
* * * * * * *
16.5. Amendments. Amendments to this Agreement may be
proposed by the General Partner or Limited Partners with a
Limited Partnership Percentage in excess of 50%.
* * * * * * *
16.5.2. In addition to any amendments otherwise
authorized herein, the General Partner may, without
obtaining the consent of the Limited Partners, amend this
Agreement from time to time:
(a) To add to the representations, duties or
obligations of the General Partner or its
affiliates or surrender any right or power granted
to the General Partner or its affiliates herein,
for the benefit of the Limited Partners; and
(b) To cure any ambiguity, to correct or
supplement any provision herein * * * which may be
inconsistent with any other provision herein, or
to make any other provisions with respect to
matters or questions arising under this Agreement
* * * as the case may be, which will not be
inconsistent with the provisions of this Agreement
* * *, provided that the Partnership receives a
written opinion of independent counsel that such
amendment does not adversely [a]ffect the
interests of the Limited Partners.
* * * * * * *
(e) Upon advice of counsel that the operations of
the Partnership are in violation of law, to cause
this Agreement to comply with law; provided,
however, such amendments shall not alter
materially the economic objectives of the
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Partnership and, further, provided that any
amendment to or deletion of any provision shall
not in the opinion of the General Partners
materially reduce the economic return to the
Limited Partners.
The Management Contract With SCA Management
Pursuant to the provisions of paragraph 12 of the General
Partnership agreement, supra, and paragraph 7.3 of the Operating
Partnership agreement, supra, on April 30, 1990, the Operating
Partnership entered into a contract with SCA Management, whereby
SCA Management was retained “for the purpose of rendering
management, administration and purchasing services and support,
and all other management support needed for operation and, in the
best interest, of the [Surgery] Center”. The management
agreement is signed on behalf of both the Operating Partnership
and SCA Management by David E. Crockett, in his capacities as
secretary and vice president, respectively, of these two
entities.
Pursuant to the management contract, SCA Management has
wide-ranging authority for operational management of the Surgery
Center, except that it has “no power or authority to make any
decision relating to the care or treatment of patients or other
medical matters”, this power and authority being specifically
reserved to the Operating Partnership’s Medical Advisory
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Committee.7 SCA Management is authorized to enter into contracts
relating to the affairs of the Surgery Center, subject to certain
exceptions, requiring express authorization of the Operating
Partnership. These exceptions include lease or contractual
obligations requiring payments in excess of $50,000 in any 12-
month period, and obligations to a related party in excess of
$5,000.
The management contract states that SCA Management is
authorized to provide services to the Operating Partnership
(referred to as “the Owner” in the following quoted provisions),
as follows:
II. MANAGEMENT SERVICES
1. Subject to the provisions of Article I, the
Manager will render all services, direction, advice,
supervision and assistance in the operation of the Center,
as necessary, including, but not in any way limited to, the
following:
A. Maintaining the accreditation of the Center
with the proper agencies and insurance companies;
B. Arranging for the purchase by the Owner of
hazard, liability, professional and other necessary
insurance coverage for the Center; provided, however,
that the physicians practicing in the Center shall
obtain their own malpractice insurance;
C. Employing, supervising, directing, leasing and
discharging on behalf of the Owner, all non-physician
personnel performing services at the Center, including
7
Under paragraph 9.6 of the Operating Partnership
agreement, the general partner (i.e., the General Partnership)
determines what are medical standards and policies.
- 22 -
the administrator of the Center, as needed. The
administrator shall be subject to the Owner's approval.
D. Negotiating fee payment methods, including
Medicare reimbursement, with the appropriate third
party payers and state and federal agencies;
E. Establishing staffing schedules, wage
structures and personnel policies for all personnel;
F. Determining and setting patient charges for
services provided by the Center, excluding charges for
physicians' services, and arranging for payment of such
charges by others, when appropriate;
G. Providing administrative policies and non-
medical operating procedures to all departments;
H. Providing standard formats for all charts,
invoices and other forms used in the operation of the
Center;
I. Providing for the purchase or lease by the
Owner of all supplies and equipment used in the
operation of the Center;
J. Directing the day-to-day operations of the
Center to insure the operations are conducted in a
business-like manner;
K. Developing an ongoing advertising and
promotion program;
L. Negotiating or retaining on behalf of the
Owner contractual relationships for anesthesiology,
radiology and pathology services, as appropriate; and
M. Performing all management and non-medical
oversight responsibilities for the Owner.
2. All costs and expenses incurred with respect to the
services specified in Paragraph 1 above will be borne by the
Manager.
III. ACCOUNTING AND BOOKKEEPING SERVICES
1. The Manager agrees to review, direct and supervise
the following accounting and bookkeeping services for the
Owner in the operation of the Center.
- 23 -
A. Receipt for and deposit in a special bank
account selected by the Owner, separate from all other
monies of the Manager, all funds received from the
operation of the Center and supervise the disbursement
of such funds for the operating expenses of the Center;
B. Maintain the books of account, including all
journals and ledgers, check register and payroll
records;
C. Post all patient and other charges, including
necessary analysis and corrections;
D. Establish adequate receivable, credit and
collection policies and procedures;
E. Process vendor's invoices and other accounts
payable;
F. Prepare payroll checks from time sheet
summaries prepared under the Manager's supervision;
G. Prepare payroll and supervise preparation of
the Owner's tax returns (fees paid to independent
accountants will be the responsibility of the Owner);
H. Prepare monthly bank reconciliations;
I. Prepare and distribute to the Owner monthly
profit and loss statements;
J. Establish patient insurance billing
procedures;
K. Furnish the Owner on or before the 30th day
following the end of each calendar quarter (i) an
accrual basis balance sheet of the Owner at the end of
the previous quarter and (ii) an accrual basis
statement of income for the quarter then ended of
"available cash" at the end of such quarter and (iii) a
list of all outstanding and unpaid obligations of the
Owner at the end of such quarter. * * *
L. Furnish the Owner for its approval, during the
fourth quarter of each fiscal year, the operating
budget and capital expenditure budget of the Center for
the next fiscal year.
- 24 -
Under the management contract, SCA Management is entitled to
receive a monthly management fee equal to 6 percent of gross
revenues, defined as the net collectable portion of revenues
billed as fees or other charges arising out of the operation of
the Surgery Center, with no deduction for bad debts. In
addition, SCA Management is entitled to be reimbursed for direct
expenses incurred in managing the Surgery Center. The Operating
Partnership is required to approve any single expense in excess
of $5,000.
The term of the management contract is equal “to the term of
any indebtedness, lease or other obligation of the * * *
[Operating Partnership] guaranteed by SCA or an affiliate of SCA
but not less than 15 years.” The management agreement is
renewable by SCA Management at its option for two 5-year terms.
Except for circumstances involving bankruptcy or insolvency, the
management contract is terminable by the Operating Partnership
only if SCA Management breaches the agreement, and then generally
only after a 90-day notice and 90-day cure period.
Managing Directors of the General Partnership
As indicated in paragraph 4 of the General Partnership
agreement, supra, overall management of the General Partnership,
except for questions of medical standards and medical policies,
is vested in its managing directors, consisting of four persons,
two of whom are appointed by petitioner, and two of whom are
- 25 -
appointed by SCA Centers. The managing directors of the General
Partnership meet on a quarterly basis. Their activities and
responsibilities include:
a. Developing and approving the Surgery Center's
capital and operating budgets;
b. Approving distributions of the Surgery Center's
earnings;
c. Hiring and firing the Surgery Center's manager;
d. Reviewing the Surgery Center's financial results;
e. Reviewing proposed capital equipment purchases of
the Surgery Center;
f. Appointing one-half of the members of the Surgery
Center Medical Advisory Committee;
g. Facilitating the lending of equipment from
Redlands Hospital to the Surgery Center;
h. Reviewing the Surgery Center's use of nursing
staff;
i. Coordinating training and mentoring opportunities
between Redlands Hospital and the Surgery Center;
j. Approving any long-term debt obligations;
k. Approving any obligations for repairs, equipment,
additions, or betterments to the Surgery Center;
l. Approving any lease or contractual obligations
requiring payments in excess of $50,000 in the aggregate for
- 26 -
any twelve-month period or those obligations not in the
ordinary course of business; and
m. Approving any obligation to a related party in
excess of $5,000.
Quality Assurance Agreement
Paragraph 13 of the General Partnership agreement, supra,
requires SCA Management to enter into a quality assurance
agreement with RHS whereby RHS will agree to perform “certain
managerial and supervisory quality assurance duties” in
connection with the operation of the Surgery Center. The General
Partnership agreement provides that the quality assurance
agreement is to continue from year to year unless terminated by
either of the parties.
Effective April 30, 1990, SCA Management and RHS entered
into a quality assurance agreement. The agreement states that
SCA Management “retains RHS for the purpose of the management and
supervision of quality assurance programs for the [Surgery]
Center and [to] oversee its affairs, and for providing additional
services as SCA [Management] may reasonably request.”
The quality assurance agreement recites as one of its
premises that SCA Management “desires to reimburse RHS for
certain services, including without limitation management and the
supervision of quality assurance programs with respect to the
[Surgery] Center.” Under the quality assurance agreement, RHS
- 27 -
was to receive no fee during the first year and thereafter was to
be paid a monthly fee equal to 1 percent of gross revenues. In
addition, SCA Management was to reimburse RHS for its direct out-
of-pocket expenses incurred in managing and supervising the
quality assurance program. The quality assurance agreement
states that RHS' appointees as managing directors shall not
receive any compensation from SCA Management, but that SCA
Management shall reimburse them for all reasonable travel
expenses and out-of-pocket expenses.
On September 30, 1990, RHS transferred its obligations and
rights under the Quality Assurance Agreement to petitioner.
By its terms, the quality assurance agreement was to
continue from year to year unless terminated by either SCA
Management or petitioner. The quality assurance agreement was to
terminate automatically, however, if the number of surgical cases
performed at the Surgery Center was less than 4,225 during any
year. The agreement states that if it is terminated for any
reason, the parties agree to negotiate in good faith an agreement
on substantially the same terms.
Medical Advisory Group
Pursuant to paragraph 9.6 of the Operating Partnership
agreement, supra, all questions regarding medical standards and
policies at the Surgery Center are determined by a Medical
Advisory Group, which also reviews procedures being performed at
- 28 -
the Surgery Center. The Medical Advisory Group is composed of
six physicians who are all limited partners of the Operating
Partnership. The managing directors of the General Partnership
select three members of the medical advisory group; Beaver
Medical Clinic--which is a limited partner in the Operating
Partnership--selects the other three members. Prior to the
affiliation of the General Partnership with the Surgery Center,
the Medical Advisory Group was inactive.
Redlands Surgical Services (Petitioner)
On August 1, 1990, 5 months after entering into the General
Partnership agreement, RHS incorporated petitioner as a
California nonprofit public benefit corporation. On September
30, 1990, RHS transferred its interest in the General Partnership
to petitioner.
RHS formed petitioner with the intent that petitioner's sole
planned activity would be its efforts with respect to the
Operating Partnership. The decisions to incorporate petitioner
as a separate corporate entity and to transfer the interests in
the General Partnership to petitioner were made to protect
Redlands Hospital and Redlands Foundation from potential
creditors of the Surgery Center and to keep petitioner's and the
Surgery Center's activities free of the debt covenants of
Redlands Hospital.
- 29 -
Petitioner’s articles of incorporation state in relevant
part:
ONE: The name of this Corporation is REDLANDS SURGICAL
SERVICES.
TWO: This Corporation is a nonprofit public benefit
corporation and is not organized for the private
gain of any person. It is organized under the
Nonprofit Public Benefit Corporation Law for
charitable purposes. The corporation is organized
solely for the benefit of, and to carry out the
charitable purposes as stated in the respective
Articles of Incorporation of (a) RHS Corp., a
California nonprofit corporation, (b) Redlands
Community Hospital, a California nonprofit
Corporation, and (c) Redlands Community Hospital
Foundation, a California nonprofit corporation.
* * * * * * *
FOUR: (a) The property of this corporation is
irrevocably dedicated to charitable purposes, and
no part of the net income or assets of this
corporation shall ever inure to the benefit of any
director, officer or member of this corporation,
or to the benefit of any private individual.
* * * * * * *
FIVE: (a) This corporation is organized exclusively for
charitable purposes within the meaning of Section
501(c)(3) of the Internal Revenue Code.
Notwithstanding any other provisions of these
Articles, the corporation shall not carry on any
activities not permitted to be carried on (i) by a
corporation exempt from Federal income tax under
Section 501(c)(3) of the Internal Revenue Code of
1954, as amended (or the corresponding provision
of any future United States Internal Revenue Law
or (ii) by a corporation, contributions to which
are deductible under Section 170(c)(2) of the
Internal Revenue Code of 1954, as amended (or the
corresponding provision of any future United
States Internal Revenue Law).
- 30 -
Petitioner's bylaws limit membership to one member. The
sole member is RHS, which has the right to elect, remove, and
fill vacancies in petitioner's Board of Directors. Petitioner's
bylaws provide that the directors must be among those persons
serving as members of the Enterprise Committee of petitioner's
parent corporation RHS.
Petitioner's sole source of financial support is its share
of the revenues from the Operating Partnership. Petitioner has
no paid or salaried employees. The president of Redlands
Hospital serves concurrently as petitioner’s president.
The Surgery Center's Operations
The Surgery Center operates on a nondiscriminatory basis
both as to doctors and patients. There are no restrictions as to
whether a surgical patient can be operated on at the Surgery
Center, other than a review as to the appropriateness of
conducting the surgical procedure in an outpatient setting and
the overall medical condition of the patient. There is
practically a 100-percent overlap between surgeons who operate at
Redlands Hospital and at the Surgery Center.
Between 1990 and 1995, the number of surgical procedures
performed at the Surgery Center increased 10 percent. Over the
same period, the number of outpatient surgeries performed at
Redlands Hospital decreased from 2,239 to 1,864.8
8
The administrative record does not reflect the number of
(continued...)
- 31 -
Procedures Authorized To Be Performed at the Surgery Center
The General Partnership agreement specifies the types of
medical services and procedures to be available at the Surgery
Center, which include: Arthroscopic surgeries, laproscopic
surgeries (including hysterectomies and appendectomies),
conizations, tonsillectomies, herniorrhaphy and eye surgeries.
When such procedures involve a higher-risk patient, they are
performed at Redlands Hospital or another acute-care hospital.
The decision to perform surgery at a hospital rather than at the
Surgery Center is exclusively a medical decision.
The General Partnership agreement generally provides that,
unless otherwise approved by the managing directors, the Surgery
Center will not perform new surgical procedures until they are
available on a nonhospital, outpatient basis at a majority of
freestanding outpatient surgery facilities in the area. If the
managing directors deadlock over approval of new procedures, the
arbitration provisions of the partnership agreement do not apply
to break the deadlock.
Petitioner's appointees to the managing directors have
successfully blocked various proposals by SCA Centers that
additional surgical procedures be conducted at the Surgery
Center. For example:
8
(...continued)
outpatient surgical procedures performed at the Surgery Center or
Redlands Hospital since 1995.
- 32 -
-- SCA Centers requested that Redlands Hospital transfer all
of its outpatient surgery volume to the Surgery Center.
Petitioner's appointees to the managing directors, however,
did not feel that this was an appropriate use of the
facility nor in the best interests of Redlands Hospital and
voted against this proposal. As a result, outpatient
surgeries continue to be performed at Redlands Hospital.
-- SCA Centers proposed that the Surgery Center offer new
surgical procedures that would require the patient to stay
overnight to recover. Petitioner's representatives did not
think this was an appropriate service to offer at the
Surgery Center and voted against performing these procedures
at the Surgery Center. As a result, surgical procedures
that require 24-hour recovery time are performed at a
hospital.
-- SCA Centers proposed that physicians be permitted to
perform retinal attachments at the Surgery Center and
requested that the Surgery Center purchase the necessary
equipment for the surgical procedure. Petitioner did not
believe there was sufficient volume in the Redlands patient
community to maintain quality control over this type of
surgery, and so its two appointees to the managing directors
voted against the purchase of the equipment and the
- 33 -
performance of this type of eye surgery at the Surgery
Center.
In addition, petitioner’s appointees to the board of
directors voted against SCA Center’s proposal to bill on behalf
of Redlands Hospital for outpatient surgeries performed there.
Payment for Services
The Surgery Center's charges are determined on the basis of
customary and usual charges for similar services provided by
other organizations in the area. The Surgery Center offers no
free care to indigents and has no emergency room or certification
to treat the emergency patient population. For persons who are
unable to pay, an effort is made to provide all necessary
services and to assist the patient in qualifying for appropriate
medical coverage including Medi-Cal. The Surgery Center also
provides payment plans for patients to make payment for
procedures more affordable.
Since the General Partnership acquired its interest in the
Operating Partnership, the Surgery Center has accepted more
managed care (i.e., care provided by health maintenance
organizations (HMO's)). Prior to April 1990, the Surgery Center
had HMO contracts with 7 HMO's and preferred provider
organizations (PPO's). As of April 1994, the Surgery Center had
contracts with 21 HMO's and PPO's. For the last 6 months of
1993, managed care (i.e., care provided by HMO's and PPO's)
- 34 -
accounted for almost half of the Surgery Center's total facility
invoices. The General Partnership agreement states that Redlands
Hospital agrees to recognize the Surgery Center as an affiliate
for managed care services to the extent legally permissible.
For the last 6 months of 1993, Medicare accounted for about
12 percent of total Surgery Center invoices. Because greater
medical risks attend surgery of older patients, such as the
typical Medicare patient, most Medicare surgeries are performed
in a hospital setting, rather than in a surgery center.
Medicaid reimbursements are substantially below those
provided by Medicare. Medi-Cal is the State of California's
Medicaid program under Federal law. The California Medi-Cal
patient group consists, in large part, of indigents, mothers, and
children. These patients' greatest needs are for emergency room
and obstetrics and gynecology (OB/GYN) medical service. As a
result, this group of patients is more likely to avail themselves
of the emergency room facilities at Redlands Hospital rather than
either Redlands Hospital's or the Surgery Center's surgical
facilities.
The Surgery Center has no contract with Medi-Cal directly,
although a negligible amount of Medi-Cal coverage is provided for
surgeries performed at the Surgery Center pursuant to
participating hospital agreements between Redlands Hospital and
the Blue Cross of California Medi-Cal Managed Care Program,
effective December 1, 1994, and between Redlands Hospital and
- 35 -
PacifiCare of California, a California HMO, effective June 1,
1994. For the last 6 months of 1993, the Surgery Center's
Medicaid invoices totaled 18, or less than 1 percent (8/10 of 1
percent) of all its invoices.
Integration of the Activities of Redlands Hospital and the
Surgery Center
Since its affiliation with the General Partnership, the
Surgery Center has served as a training site for Redlands
Hospital nurses in outpatient procedures. Redlands Hospital
nursing surgery staff members train at the Surgery Center in
circumstances where the frequency of a particular surgery at the
Surgery Center makes such training more efficient and economical.
This is especially true of procedures that are more often
performed at the Surgery Center than at Redlands Hospital (e.g.,
tonsillectomy and cataract surgeries).
To be a member of the Redlands Hospital physician staff, a
physician must be board-certified in his or her specialty and
regarded by Redlands Hospital as a capable practitioner.
Redlands Hospital uses a "proctory" review process to approve new
members of its physician staff. Before the General Partnership
acquired its interest in the Surgery Center, no proctoring was
conducted at the Surgery Center. Since the affiliation of the
Surgery Center with the General Partnership, it is frequently the
case that, as new surgeons join Redlands Hospital's staff, the
- 36 -
Redlands Hospital proctoring requirements are satisfied, in whole
or in part, during surgeries performed at the Surgery Center.
Redlands Hospital has been involved in teaching new
procedures to be performed at the Surgery Center. An example is
laser arthroscopic surgery, which eliminates incision. These
procedures were developed at Redlands Hospital, and the knowledge
was shared with the Surgery Center.
The Surgery Center’s Financial Results
The Surgery Center’s profit levels and payor mix are
comparable to other ambulatory surgery centers. Its profits are
used for equipment additions, replacements, improvements in
services, and cash distributions to the partners.
In the first 5-month period after April 30, 1990, when the
amended Operating Partnership and the SCA Management contract
became effective, the Operating Partnership had net income of
$451,430, which was 34.5 percent of gross revenues. SCA
Management received $80,458 in fees.
Cash distributions from the Operating Partnership to
petitioner, SCA Centers, and the limited partners, expressed as
an average rate of return on investment basis for fiscal years
1990-1993, were as follows:
- 37 -
Average Rates of Return
FY90 FY91 FY92 FY93 FY90-FY93
Petitioner 6.3% 24.9% 34.9% 43.5% 27.4%
SCA Centers 4.4% 17.3% 25.4% 31.5% 19.6%
Limited Partners 5.1% 21.4% 31.0% 38.5% 24.0%
Upon its Form 1023, Application for Recognition of
Exemption, under section 501(c)(3), filed August 7, 1990,
petitioner estimated that between 50 and 80 percent of its total
annual income would be used to support RHS and Redlands Hospital,
which were stated to have total annual losses of $340,544 and
$460,595, respectively. Petitioner has used its share of the
cash distributions from the Operating Partnership to pay off the
note payable to SCA for its initial capital contribution9 and to
make distributions to RHS or Redlands Hospital.
Final Adverse Ruling
In its final adverse ruling, respondent determined that
petitioner is "not operated exclusively for charitable purposes
within the meaning of section 501(c)(3). You are operating for a
substantial nonexempt purpose and your operations benefit private
interests more than incidentally."
9
The note payable to SCA of $769,829 was paid in full by
April 1992.
- 38 -
Petitioner has exhausted its administrative remedies within
the Internal Revenue Service.
OPINION
I. The Parties’ Positions
Respondent contends that petitioner is not operated
exclusively for charitable purposes because it operates for the
benefit of private parties and fails to benefit a broad cross-
section of the community. In support of its position, respondent
contends that the partnership agreements and related management
contract are structured to give for-profit interests control over
the Surgery Center. Respondent contends that both before and
after the General Partnership acquired an ownership interest in
it, the Surgery Center was a successful profit-making business
that never held itself out as a charity and never operated as a
charitable health-care provider.
Petitioner argues that it meets the operational test under
section 501(c)(3) because its activities with regard to the
Surgery Center further its purpose of promoting health for the
benefit of the Redlands community, by providing access to an
ambulatory surgery center for all members of the community based
upon medical need rather than ability to pay, and by integrating
the outpatient services of Redlands Hospital and the Surgery
Center. Petitioner argues that its dealings with the for-profit
partners have been at arm's length, and that its influence over
- 39 -
the activities of the Surgery Center has been sufficient to
further its charitable goals. Petitioner further contends that
it qualifies for exemption because it is organized and operated
to perform services that are integral to the exempt purposes of
RHS, its tax-exempt parent, and Redlands Hospital, its tax-exempt
affiliate.
II. Applicable Legal Principles
A. Operational Test
To qualify for exemption from Federal income tax, an
organization must be “organized and operated exclusively for
* * * charitable * * * purposes”. Sec. 501(c)(3); see Church of
Scientology v. Commissioner, 823 F.2d 1310, 1315 (9th Cir. 1987),
affg. 83 T.C. 381 (1984).
The applicable regulations provide as follows:
(c) Operational test--(1) Primary activities. An
organization will be regarded as “operated exclusively” for
one or more exempt purposes only if it engages primarily in
activities which accomplish one or more of such exempt
purposes specified in section 501(c)(3). An organization
will not be so regarded if more than an insubstantial part
of its activities is not in furtherance of an exempt
purpose. [Sec. 1.501(c)(3)-1(c)(1), Income Tax Regs.]
The operational test focuses on the actual purposes the
organization advances by means of its activities, rather than on
the organization's statement of purpose or the nature of its
activities. See American Campaign Academy v. Commissioner, 92
T.C. 1053, 1064 (1989); Goldsboro Art League, Inc. v.
- 40 -
Commissioner, 75 T.C. 337, 343 (1980); Aid to Artisans, Inc. v.
Commissioner, 71 T.C. 202, 210-211 (1978). To determine whether
the operational test has been satisfied, we look beyond “the four
corners of the organization’s charter to discover 'the actual
objects motivating the organization'”. American Campaign Academy
v. Commissioner, supra at 1064.
Although an organization might be engaged in only a single
activity, that single activity might be directed toward multiple
purposes, both exempt and nonexempt. If the nonexempt purpose is
substantial in nature, the organization will not satisfy the
operational test. See KJ’s Fund Raisers, Inc. v. Commissioner,
166 F.3d 1200 (2d Cir. 1998), affg. without published opinion
T.C. Memo. 1997-424; Manning Association v. Commissioner, 93 T.C.
596, 603-605 (1989); American Campaign Academy v. Commissioner,
supra at 1065; Copyright Clearance Ctr., Inc. v. Commissioner, 79
T.C. 793, 804 (1982). “The presence of a single * * * [non-
exempt] purpose, if substantial in nature, will destroy the
exemption regardless of the number or importance of truly * * *
[exempt] purposes.” Better Bus. Bureau, Inc. v. United States,
326 U.S. 279, 283 (1945).
The fact that an organization engages in a trade or business
is not conclusive of a substantial nonexempt purpose and does
not, in and of itself, disqualify the organization from exemption
under section 501(c)(3), provided the activity furthers or
- 41 -
accomplishes an exempt purpose. See Federation Pharmacy Servs.,
Inc. v. Commissioner, 72 T.C. 687, 691 (1979), affd. 625 F.2d 804(8th Cir. 1980); est of Hawaii v. Commissioner, 71 T.C. 1067,
1079 (1979), affd. without published opinion 647 F.2d 170 (9th
Cir. 1981); secs. 1.501(c)(3)-1(c)(1) and 1.501(c)(3)-1(e)(1),
Income Tax Regs.
Whether an organization has a substantial nonexempt purpose
is a question of fact to be resolved on the basis of all the
evidence presented by the administrative record. See B.S.W.
Group, Inc. v. Commissioner, 70 T.C. 352, 357 (1978); see also
Church by Mail, Inc. v. Commissioner, 765 F.2d 1387, 1390 (9th
Cir. 1985), affg. T.C. Memo. 1984-349; est of Hawaii v.
Commissioner, supra at 1079. “Factors such as the particular
manner in which an organization’s activities are conducted, the
commercial hue of those activities, and the existence and amount
of annual or accumulated profits are relevant evidence of a
forbidden predominant purpose.” B.S.W. Group, Inc. v.
Commissioner, supra at 358.
The burden of proof is on petitioner to demonstrate, based
on materials in the administrative record, that it is operated
exclusively for exempt purposes and that it does not benefit
private interests more than incidentally. See Rule 217(c)(2)(A);
Church of Scientology v. Commissioner, 823 F.2d at 1317; Florida
Hosp. Trust Fund v. Commissioner, 103 T.C. 140, 146 (1994), affd.
- 42 -
71 F.3d 808 (11th Cir. 1996). For purposes of this proceeding,
we assume that the facts as represented in the administrative
record are true, although in the course of our review we may draw
our own ultimate conclusions and inferences from the facts. See
American Campaign Academy v. Commissioner, supra at 1063-1064;
Houston Lawyer Referral Serv., Inc. v. Commissioner, 69 T.C. 570,
573-575 (1978).
B. Promotion of Health as a Charitable Purpose
Section 501(c)(3) specifies various qualifying exempt
purposes, including “charitable” purposes. The term “charitable”
is not defined in section 501(c)(3), but is used in its generally
accepted legal sense. See Nationalist Movement v. Commissioner,
102 T.C. 558 (1994), affd. per curiam 37 F.3d 216 (5th Cir.
1994); sec. 1.501(c)(3)-1(d)(2), Income Tax Regs. In applying
this standard, courts have looked to the law of charitable
trusts. See Sound Health Association v. Commissioner, 71 T.C.
158, 177 (1978); see also Bob Jones Univ. v. United States, 461
U.S. 574, 588 n.12 (1983).
The promotion of health for the benefit of the community is
a charitable purpose. See Eastern Ky. Welfare Rights Org. v.
Simon, 506 F.2d 1278, 1288-1289 (D.C. Cir. 1974), vacated on
other grounds 426 U.S. 26 (1976); Sound Health Association v.
Commissioner, supra at 177-181; see also 2 Restatement, Trusts
2d, secs. 368, 372 (1959); 4A Scott & Fratcher, Law of Trusts,
- 43 -
secs. 368, 372 (4th ed. 1989). As applied to determinations of
qualification for tax exemption, the definition of the term
“charitable” has not been static. See Eastern Ky. Welfare Rights
Org. v. Simon, supra at 1287-1290; Sound Health Association v.
Commissioner, supra. Suffice it to say that, in recognition of
changes in the health-care industry, the standard no longer
requires that “the care of indigent patients be the primary
concern of the charitable hospital, as distinguished from the
care of paying patients”. Sound Health Association v.
Commissioner, supra at 180. Rather, the standard reflects "a
policy of insuring that adequate health care services are
actually delivered to those in the community who need them.” Id.
at 180-181. Under this standard, health-care providers must meet
a flexible community benefit test based upon a variety of
indicia, one of which may be whether the organization provides
free care to indigents. Cf. id. at 184-185 (subsidized dues
program was an indicium of charitable purposes).
To benefit the community, a charity must serve a
sufficiently large and indefinite class; as a corollary to this
rule, private interests must not benefit to any substantial
degree. See id. at 181.
C. Proscription Against Benefiting Private Interests
An organization does not operate exclusively for exempt
purposes if it operates for the benefit of private interests such
- 44 -
as designated individuals, the creator or his family,
shareholders of the organization, or persons controlled, directly
or indirectly, by such private interests. See sec. 1.501(c)(3)-
1(d)(1)(ii), Income Tax Regs. The private benefit proscription
inheres in the requirement that an organization operate
exclusively for exempt purposes.
As stated in American Campaign Academy v. Commissioner, 92
T.C. 1053, 1065-1066 (1989):
When an organization operates for the benefit of
private interests such as designated individuals, the
creator or his family, shareholders of the
organization, or persons controlled, directly or
indirectly, by such private interests, the organization
by definition does not operate exclusively for exempt
purposes. Prohibited private benefits may include an
“advantage; profit, fruit; privilege; gain; [or]
interest.” Occasional economic benefits flowing to
persons as an incidental consequence of an organization
pursuing exempt charitable purposes will not generally
constitute prohibited private benefits. Thus, should
* * * [the organization] be shown to benefit private
interests, it will be deemed to further a nonexempt
purpose under section 1.501(c)(3)-1(d)(1)(ii), Income
Tax Regs. This nonexempt purpose will prevent [the
organization] from operating primarily for exempt
purposes absent a showing that no more than an
insubstantial part of its activities further the
private interests or any other nonexempt purposes.
[Citations and fn. ref. omitted.]
The proscription against private benefit shares common
elements with, but is distinct from, the proscription against the
inurement of organizational earnings to private shareholders and
individuals, as contained in section 501(c)(3) and sections
1.501(a)-1(c) and 1.501(c)(3)-1(c)(2), Income Tax Regs. See
- 45 -
American Campaign Academy v. Commissioner, supra at 1068. The
proscription against private benefit encompasses not only
benefits conferred on insiders having a personal and private
interest in the organization, but also benefits conferred on
unrelated or disinterested persons. See id.; Christian
Stewardship Assistance, Inc. v. Commissioner, 70 T.C. 1037(1978).
The mere fact that an organization seeking exemption enters
into a partnership agreement with private parties that receive
returns on their capital investments does not establish that the
organization has impermissibly conferred private benefit. The
question remains whether the organization has a substantial
nonexempt purpose whereby it serves private interests. Compare
Plumstead Theatre Socy., Inc. v. Commissioner, 675 F.2d 244 (9th
Cir. 1982), affg. per curiam 74 T.C. 1324 (1980) (a nonprofit
arts organization furthered its charitable purposes by
participating as sole general partner in a partnership with
private parties to produce a play), with Housing Pioneers, Inc.
v. Commissioner, 49 F.3d 1395 (9th Cir. 1995), affg. T.C. Memo.
1993-120 (a nonprofit corporation’s participation as co-general
partner in low-income housing partnerships, structured to trade
off its tax exemption to secure tax benefits for its for-profit
partners, had a substantial nonexempt purpose and impermissibly
served private interests).
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The proscription against private benefit corresponds to a
similar proscription in the law of charitable trusts. “A trust
is not a charitable trust if the property or the income therefrom
is to be devoted to a private use.” 2 Restatement, Trusts 2d,
sec. 376 (1959). An organization’s property may be impermissibly
devoted to a private use where private interests have control,
directly or indirectly, over its assets, and thereby secure
nonincidental private benefits.
For instance, in est of Hawaii v. Commissioner, 71 T.C. 1067(1979), several for-profit ‘est’ organizations that had no formal
structural control over the nonprofit entity in question
nevertheless exerted "considerable control" over its activities.
The for-profit organizations set fees that the nonprofit charged
the public for training sessions, required the nonprofit to carry
on certain types of educational activities, and provided
management personnel paid for and responsible to one of the for-
profits. Under a licensing agreement with the for-profits, the
nonprofit was allowed to use certain intellectual property for 10
years, and at the end of the licensing agreement, all copyrighted
material, including new material developed by the nonprofit, was
required to be turned over to the for-profits. The nonprofit was
required to use its excess funds for the development of ‘est’ or
related research. The for-profits also required that trainers
and local organizations sign an agreement not to compete with
- 47 -
‘est’ for 2 years after terminating their relationship with ‘est’
organizations.
In est of Hawaii v. Commissioner, supra at 1080, this Court
agreed with respondent that the nonprofit was “part of a
franchise system which is operated for private benefit and * * *
its affiliation with this system taints it with a substantial
commercial purpose.” We found that the “ultimate beneficiaries”
of the nonprofit’s activities were the for-profit corporations,
and that the nonprofit “was simply the instrument to subsidize
the for-profit corporations and not vice versa”. Id. at 1082.
This Court held that the nonprofit was not operated exclusively
for exempt purposes. See also Harding Hosp., Inc. v. United
States, 505 F.2d 1068 (6th Cir. 1974) (impermissible private
benefit resulted from a nonprofit hospital's contract with a
physician group, giving them a virtual monopoly over care of the
hospital's patients and the income stream they represented, and
providing the physician group with fees for supervising the
hospital's medical staff); Sonora Community Hosp. v.
Commissioner, 46 T.C. 519 (1966) (impermissible private benefit
resulted from an arrangement whereby a for-profit laboratory was
permitted to occupy space in the nonprofit hospital rent-free,
and paid the hospital’s founding doctors a share of the
laboratory’s gross revenues in consideration of patient referrals
and administrative services), affd. 397 F.2d 814 (9th Cir. 1968).
- 48 -
III. Petitioner’s Claim to Exemption on a “Stand-Alone” Basis
Applying the principles described above, we next consider
whether petitioner has established that respondent improperly
denied it tax-exempt status as a section 501(c)(3) organization.
A. The Relevance of Control--The Parties’ Positions
Respondent asserts that petitioner has ceded effective
control over its sole activity--participating as a co-general
partner with for-profit parties in the partnerships that own and
operate the Surgery Center--to the for-profit partners and the
for-profit management company that is an affiliate of
petitioner’s co-general partner. Respondent asserts that this
arrangement is indicative of a substantial nonexempt purpose,
whereby petitioner impermissibly benefits private interests.
Without conceding that private parties control its
activities, petitioner challenges the premise that the ability to
control its activities determines its purposes. Petitioner
argues that under the operational test, “the critical issue in
determining whether an organization’s purposes are noncharitable
is not whether a for profit or not for profit entity has control.
Rather, the critical issue is the sort of conduct in which the
organization is actually engaged.” On brief, the parties agree
that under an aggregate theory of partnership taxation, the
partnerships’ activities are considered petitioner’s own
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activities. Petitioner’s brief states: “The evidence in the
administrative file demonstrates that * * * [the Operating
Partnership] has been operated in an exclusively charitable
manner since 1990". Therefore, petitioner concludes, it should
be deemed to operate exclusively for charitable purposes.
We disagree with petitioner’s thesis. It is patently clear
that the Operating Partnership, whatever charitable benefits it
may produce, is not operated “in an exclusively charitable
manner”. As stated by Justice Cardozo (then Justice of the New
York Court of Appeals), in describing one of the “ancient
principles” of charitable trusts, “It is only when income may be
applied to the profit of the founders that business has a
beginning and charity an end.” Butterworth v. Keeler, 219 N.Y.
446, 449-450, 114 N.E. 803, 804 (1916). The Operating
Partnership's income is, of course, applied to the profit of
petitioner’s co-general partner and the numerous limited
partners.10 It is no answer to say that none of petitioner’s
income from this activity was applied to private interests, for
the activity is indivisible, and no discrete part of the
Operating Partnership's income-producing activities is severable
10
In making these observations, we are mindful that it is
the status of petitioner, not of the General Partnership or the
Operating Partnership, that is in issue. Indeed, it is not
meaningful to speak of a partnership’s exempt status, given that
partnerships are nontaxable entities. See sec. 701.
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from those activities that produce income to be applied to the
other partners’ profit.
Taken to its logical conclusion, petitioner’s thesis would
suggest that an organization whose main activity is passive
participation in a for-profit health-service enterprise could
thereby be deemed to be operating exclusively for charitable
purposes. Such a conclusion, however, would be contrary to well-
established principles of charitable trust law.
Frequently, a business enterprise may have charitable
effects. * * * A private hospital relieves sickness and
suffering. * * * However, the primary object of these
institutions is the pecuniary gain of the operators. Hence
trusts to aid in the founding or maintenance of private
hospitals or clinics * * *, which are business enterprises
operated for the purpose of making profits for stockholders
or owners, are not charitable even though they involve
incidentally some public benefits. “It is not charity to
aid a business enterprise.” [Bogert & Bogert, The Law of
Trusts and Trustees, sec. 364 (Rev. 2d ed. 1991) (quoting
Butterworth v. Keeler, 219 N.Y. at 449, 114 N.E. at 804);
fn. refs. omitted.]
Clearly, there is something in common between the structure
of petitioner’s sole activity and the nature of petitioner’s
purposes in engaging in it. An organization’s purposes may be
inferred from its manner of operations; its “activities provide a
useful indicia of the organization’s purpose or purposes.”
Living Faith, Inc. v. Commissioner, 950 F.2d 365, 372 (7th Cir.
1991), affg. T.C. Memo. 1990-484. The binding commitments that
petitioner has entered into and that govern its participation in
the partnerships are indicative of petitioner’s purposes. To the
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extent that petitioner cedes control over its sole activity to
for-profit parties having an independent economic interest in the
same activity and having no obligation to put charitable purposes
ahead of profit-making objectives, petitioner cannot be assured
that the partnerships will in fact be operated in furtherance of
charitable purposes. In such a circumstance, we are led to the
conclusion that petitioner is not operated exclusively for
charitable purposes.
Based on the totality of factors described below, we
conclude that petitioner has in fact ceded effective control of
the partnerships’ and the Surgery Center’s activities to for-
profit parties, conferring on them significant private benefits,
and therefore is not operated exclusively for charitable purposes
within the meaning of section 501(c)(3).
B. Indicia of For-Profit Control Over the Partnerships’
Activities
1. No Charitable Obligation
Nothing in the General Partnership agreement, or in any of
the other binding commitments relating to the operation of the
Surgery Center, establishes any obligation that charitable
purposes be put ahead of economic objectives in the Surgery
Center’s operations. The General Partnership agreement does not
- 52 -
expressly state any mutually agreed-upon charitable purpose or
objective of the partnership.11
After the General Partnership acquired its 61-percent
interest, the Operating Partnership--which had long operated as a
successful for-profit enterprise and never held itself out as a
charity--never changed its organizing documents to acknowledge a
charitable purpose. Indeed, in at least one instance the
Operating Partnership agreement explicitly acknowledges the
partnership’s noncharitable objectives. Section 16.5.2 of the
Operating Partnership agreement, supra, in authorizing the
General Partnership to amend the Operating Partnership as
necessary to comply with legal requirements, specifies that this
authority may be exercised only if “such amendments do not alter
the economic objectives of the partnership or materially reduce
the economic return to the limited partners.”
11
The prefatory “Whereas” clauses to the General
Partnership agreement recite that RHS is entering into the
agreement to “insure the availability of high quality health
services in the most cost effective setting in which such
services can be rendered” and because “the use of an ambulatory
surgical center will contribute to RHS’s goal of providing
comprehensive health care services at an affordable price.” The
partnership agreement, however, does not reflect that this was a
mutual premise. The partnership agreement states as the purpose
of the partnership merely the acquiring of a 61-percent interest
in the Operating Partnership, stating that the General
Partnership “may engage in any and all other activities as may be
necessary, incidental or convenient to carry out the business of
the Partnership as contemplated by this Agreement.”
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2. Petitioner’s Lack of Formal Control
a. Managing Directors
Under the General Partnership agreement, control over all
matters other than medical standards and policies is nominally
divided equally between petitioner and SCA Centers, each
appointing two representatives to serve as managing directors.
(As discussed infra, matters of medical standards and policies
are determined by the Medical Advisory Group, half of whom are
chosen by the General Partnership’s managing directors.)
Consequently, petitioner may exert influence by blocking actions
proposed to be taken by the managing directors, but it cannot
initiate action without the consent of at least one of SCA
Center’s appointees to the managing directors. For instance,
petitioner lacks sufficient control unilaterally to cause the
Surgery Center to respond to community needs for new health
services, modify the delivery or cost structure of its present
health services to serve the community better, or, as discussed
in more detail infra, terminate SCA Management, if SCA Management
were determined to be managing the Surgery Center in a manner
inconsistent with charitable objectives.
The administrative record shows that petitioner has
successfully blocked various proposals to expand the scope of
activities performed at the Surgery Center. Petitioner’s ability
to veto expansion of the scope of the Surgery Center’s
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activities, however, does not establish that petitioner has
effective control over the manner in which the Surgery Center
conducts activities within its predesignated sphere of
operations. Nor does it tend to indicate that the Surgery Center
is not operated to maximize profits with regard to those
activities. Indeed, given that all the partners except
petitioner are for-profit interests not shown to be motivated or
constrained by charitable objectives, and given that all the
limited partners except Beaver Medical Clinic were issued SCA
common stock when the General Partnership acquired its interest
in the Operating Partnership, and given that SCA Management
derives a management fee computed as a percentage of gross
revenues, we find, in the absence of evidence to the contrary,
that a significant profit-making objective is present in the
Surgery Center’s operations. The high rates of return earned on
the partners’ investments (including petitioner’s) in the
Operating Partnership bolster this finding.
In sum, the composition of the managing directorship
evidences a lack of majority control by petitioner whereby it
might assure that the Surgery Center is operated for charitable
purposes.12 Consequently, we look to the binding commitments
12
The managing directors of the General Partnership are
functionally equivalent to a hospital's board of directors, the
importance of which has been described as follows:
(continued...)
- 55 -
made between petitioner and the other parties to ascertain
whether other specific powers or rights conferred upon petitioner
might mitigate or compensate for its lack of majority control.
b. Arbitration Process
The General Partnership agreement provides for an
arbitration process in the event that the managing directors of
the General Partnership deadlock over a matter other than medical
standards and medical policies, such as approval of new surgical
procedures. Under these provisions, in the event of a deadlock,
each of the co-general partners selects one arbitrator, and these
two arbitrators select a third. The arbitrators have final
authority to decide matters referred to them. The ground rules
for the arbitration process are minimal and provide petitioner no
assurance that charitable objectives will govern the outcome.
Under the General Partnership agreement, the arbitrators are not
required to take into account any charitable or community benefit
12
(...continued)
The board of directors, its composition, and its
functions are relevant to tax exemption * * * the
composition of the board provides important evidence that
the hospital serves public rather than private purposes.
For example, it is fair to presume that a board of directors
chosen from the community would place the interests of the
community above those of either the management or the
medical staff of the hospital. Thus, the relevance of the
board is that its process should indicate whether the
hospital is operated for the benefit of the community or to
secure benefits for private interests. [Mancino, “Income
Tax Exemption of the Contemporary Nonprofit Hospital”, 32
St. Louis U.L.J. 1015, 1051 (1988).]
- 56 -
objective, but are simply required to “apply the substantive law
of California”.
Petitioner asserts that since 1990, neither co-general
partner has invoked the arbitration clause. The administrative
record is inconclusive on this point. Even assuming arguendo
that petitioner’s assertion is correct, it merely tends to show
that petitioner and SCA Centers have avoided conflict with regard
to those operating decisions that are subject to arbitration.
Whether such conflicts have been avoided because petitioner’s
purposes and the purposes of its for-profit partner are so
closely aligned, or for some other reason, the administrative
record does not reveal. Clearly, however, the arbitration
process does not significantly mitigate petitioner’s lack of
majority control to provide any assurance that the General
Partnership will operate to put charitable objectives ahead of
economic objectives.
c. The Management Contract
The management contract between the Operating Partnership
and SCA Management confers broad powers on SCA Management to
enter into contracts, to negotiate with third-party payers and
State and Federal agencies, and to set patient charges for all
services provided, with the exception of charges for physicians’
services. In short, SCA Management is authorized to manage as it
sees fit many of the day-to-day operations of the Surgery Center,
- 57 -
reserving to the Medical Advisory Group of the Operating
Partnership the authority to make all medical decisions.
Under the management contract, SCA Management is entitled to
receive fees equaling 6 percent of the Operating Partnership’s
gross revenues each month, in addition to reimbursement of its
direct expenses. This revenue-based compensation structure
provides SCA Management an incentive to manage the Surgery Center
so as to maximize profits.13
As a practical matter, the Operating Partnership is locked
into the management agreement with SCA Management for at least 15
years. At its sole discretion, SCA Management may renew the
agreement for two additional 5-year periods on the same terms and
conditions. The Operating Partnership has the right to terminate
the management contract for breach, but only after the Operating
Partnership has given written notice describing in detail the
13
The management contract defines gross revenues as “the
net collectable portion of revenues billed as fees or other
charges arising out of the operation of the [Surgery] Center,
with no deduction for bad debts.” Petitioner suggests on brief
that this means that SCA Management has no disincentive to treat
patients who are unable to pay for treatment, because the “gross
revenues” on which its management fee is based would include the
chargeable amount for the services rendered. We do not find
these arguments convincing. In the first instance, the Surgery
Center does not provide charity care. Moreover, petitioner’s
argument does not address to what extent charitable services, if
they were provided, would give rise to “net collectable * * *
revenues”. Nor does petitioner’s argument address the broader
point that the management contract gives SCA Management an
economic interest to maximize revenues in all aspects of the
Surgery Center’s operations, and not just as relate to charity
care.
- 58 -
basis on which it believes termination is justified. Because the
issuance of such a termination notice would require approval by a
majority of the General Partner’s managing directors, petitioner
could not effect the issuance of such a notice without the
consent of SCA Centers, which is an affiliate of SCA Management.
Thus, even if petitioner determined that SCA Management were
managing the Surgery Center in a manner inconsistent with
charitable purposes, petitioner could not be assured of any
remedy.
Moreover, neither the General Partnership agreement, the
Operating Partnership agreement, nor the management contract
itself requires that SCA Management be guided by any charitable
or community benefit, goal, policy, or objective. Rather, the
management contract simply requires SCA Management to render
services as necessary and in the best interest of the Operating
Partnership, “subject to the policies established by [the
Operating Partnership], which policies shall be consistent with
applicable state and Federal law.”
Petitioner argues that the management contract “was
negotiated at arm’s length, between parties of equal bargaining
strength”. The administrative record does not support this
contention. Although the General Partnership agreement was
negotiated between RHS and SCA Centers, it contains only a sparse
description of several key features to be included in the
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management contract.14 The actual management contract is between
SCA Management and the Operating Partnership, and contains much
more extensive and detailed provisions than are stipulated in the
General Partnership agreement. Notably, the term of the
management agreement is at variance with the term stipulated in
the General Partnership agreement.15
The administrative record does not reveal that petitioner or
RHS had any role in negotiating the actual management contract.
It is executed for both the Operating Partnership and SCA
Management by the same individual--David E. Crockett--in his dual
capacities as secretary of SCA Centers and vice president of SCA
Management, raising the suggestion, if not the likelihood, of
self-dealing between these two SCA affiliates.
Respondent asserts, and we agree, that this long-term
management contract with an affiliate of SCA Centers is a salient
indicator of petitioner's surrender of effective control over the
14
The General Partnership agreement merely provides that
SCA Management will assume “full responsibility for administering
the day-to-day operation of the ambulatory center in accordance
with the goals, policies and objectives” of the Operating
Partnership, and stipulates an initial 15-year term, renewable
for two 5-year terms, and a fee equal to 6 percent of the
Operating Partnership’s gross revenues.
15
Whereas the General Partnership agreement stipulates a
15-year initial term for the management contract, the actual
management contract modifies this provision to the advantage of
SCA and its affiliates by providing that the initial term is
equal to the term of any indebtedness, lease, or other obligation
of the Operating Partnership guaranteed by SCA or SCA’s
affiliate, but not less than 15 years.
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Surgery Center’s operations to SCA affiliates, whereby the
affiliates were given the ability and incentive to operate the
Surgery Center so as to maximize profits. This surrender of
effective control reflects adversely on petitioner's own
charitable purposes in contracting to have its sole activity
managed in this fashion. Cf. est of Hawaii v. Commissioner, 71
T.C. 1067 (1979).
d. Medical Advisory Group
The Operating Partnership agreement delegates authority for
making decisions about care and treatment of patients and other
medical matters to the Operating Partnership’s Medical Advisory
Group. This group was inactive before the General Partnership
became involved with the Operating Partnership, but there is no
evidence to show what role, if any, petitioner played in
reconstituting the Medical Advisory Group.
Only three of the six members of the Medical Advisory Group
are selected by the General Partnership. The other three are
selected by one of the limited partners, Beaver Medical Clinic.
It is telling that the Medical Advisory Group is composed
entirely of limited partners of the Operating Partnership, all of
whom (except Beaver Medical Clinic) received common stock in SCA
when the General Partnership acquired its Operating Partnership
interest. Taking all these considerations into account, it is
clear that petitioner lacks sufficient influence to determine the
- 61 -
resolution of any matter brought before the Medical Advisory
Group. Moreover, there is no evidence in the record that the
decisions of the Medical Advisory Committee are subject to
independent review by petitioner or Redlands Hospital.
e. Termination of Quality Assurance Activities
As required by the General Partnership agreement, on April
30, 1990, SCA Management entered into a quality assurance
agreement with RHS. The term of the quality assurance agreement
was conditioned on maintenance of a specified level of surgery
activity in the Surgery Center. Petitioner concedes that the
quality assurance agreement terminated after the first year.16
Although the agreement required the parties to negotiate a new
quality assurance agreement in the event of such a termination,
there is no evidence in the record that such negotiations ever
occurred.17
The termination of the quality assurance agreement vividly
evidences petitioner’s lack of effective control over vital
aspects of the Surgery Center’s operations. Quality assurance
16
The termination of the quality assurance agreement is
disclosed in petitioner's reply brief, filed on May 11, 1998.
Petitioner's counsel represent that the fact of the termination
of the quality assurance agreement was first disclosed to them on
or about Apr. 30, 1998.
17
Under the quality assurance agreement, petitioner was
entitled to a fee equal to 1 percent of gross revenues,
commencing in the second year. Because the agreement terminated
after the first year, it appears that petitioner never received
any fees under the agreement.
- 62 -
agreements in the health-care industry serve the important dual
functions of attempting to avoid inappropriate services (e.g.,
the wrong services for the patient’s needs, or services that are
improperly rendered), and seeking to assure that enough services
are provided to meet the patient’s needs. See 2 National Health
Lawyers Association, Health Law Practice Guide, sec. 25.1, at 25-
3 (1997). The record does not reflect that petitioner performed
any quality assurance work. Likewise, the record is silent as to
how petitioner, in the absence of any operable quality assurance
agreement, purports to assure itself that these vital functions
will be discharged consistently with charitable objectives.
3. Lack of Informal Control
The administrative record provides no basis for concluding
that, in the absence of formal control, petitioner possesses
significant informal control by which it exercises its influence
with regard to the Surgery Center’s activities. Nothing in the
administrative record suggests that petitioner commands
allegiance or loyalty of the SCA affiliates or of the limited
partners to cause them to put charitable objectives ahead of
their own economic objectives. Indeed, until April 1992,
petitioner was in a debtor relationship to SCA. The limited
partners (except for Beaver Medical Clinic, Inc.) all became
common stockholders of SCA when the General Partnership acquired
its interest in the Operating Partnership.
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The administrative record does not establish that petitioner
has the resources or ability effectively to oversee or monitor
the Surgery Center’s operations. Petitioner has almost no
resources apart from its assets invested in the General
Partnership. The president of Redlands Hospital also serves as
petitioner’s president and as one of the four managing directors
of the General Partnership.
On brief, petitioner argues that its influence in the
partnerships is evidenced by various changes that it says
occurred in the operation of the Surgery Center after April 1990,
when the amended Operating Partnership agreement became
effective. Petitioner suggests that these operational changes
demonstrate that its influence is sufficient to allow it to
achieve its charitable goals through the partnerships' activities
and demonstrate that for-profit interests do not control the
partnerships and the Surgery Center. As described in more detail
below, the record does not support petitioner’s contentions.
a. Change in Criteria for Procedures Performed at the
Surgery Center
Petitioner asserts that after the General Partnership
acquired its interest in the Operating Partnership, “the decision
to perform a surgery at the Surgery Center was changed from an
economic to exclusively a medical decision. Accordingly, RHS
achieved its goal of providing complete access to freestanding
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ambulatory surgery center care for all members of the Redlands
community irrespective of their ability to pay.”
This proposed finding of fact is not supported by the
record. Neither before nor after petitioner’s involvement with
it has the Surgery Center provided charity care. Moreover, the
administrative record indicates that one aspect of ambulatory
surgery centers that makes them attractive investment
opportunities in the first instance is that they boast favorable
“procedure and payer mixes”.18 Consequently, it is not apparent
from the record to what extent the decision to perform a surgery
at the Surgery Center has ever been an “economic” rather than a
“medical” decision, or exactly how that situation might have
changed after April 1990.
Even if we assume, arguendo, that a change in criteria did
occur after April 1990, the record does not establish
petitioner’s role in effecting any such change.
18
The administrative record includes an investment summary
with respect to SCA and another national health-care provider,
Medical Care International, published by Shearson Lehman
Brothers, dated Aug. 7, 1991. The report states: “To a large
extent the favorable payer mix is a function of the fact that
many procedures safely performed on an outpatient basis happen to
be those with a young patient population.” Similarly, in its
arguments to justify the Surgery Center’s low rate of Medi-Cal
patients, petitioner notes that the Surgery Center does not
perform the types of procedures--emergency room treatments and
obstetrics and gynecology--that typically account for a
"substantial majority" of low-income surgical expenses for a
community.
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b. Provision for Indigent Patients
Petitioner concedes that as of December 31, 1993, Medi-Cal
patients accounted for only 0.8 percent of total procedures
performed at the Surgery Center. Petitioner argues that the type
of services which the Service Center offers is not the type of
services typically sought by low-income individuals. Petitioner
notes that Redlands Hospital has negotiated certain provider
agreements that designate the Surgery Center as a subcontractor
to provide outpatient services for Medi-Cal patients, and that
Redlands Hospital has caused the Surgery Center to increase its
number of managed care contracts. Petitioner suggests that these
efforts demonstrate petitioner’s influence over the operations of
the Surgery Center and evidence petitioner's charitable purposes.
We do not find petitioner’s arguments convincing. The facts
remain that the Surgery Center provides no free care to indigents
and only negligible coverage for Medi-Cal patients. That low-
income individuals may not typically seek the types of services
the Surgery Center offers may partially explain the virtual
absence of relief it provides for such individuals. But it
provides no independent basis for establishing petitioner’s
charitable purposes in its involvement with the Surgery Center.
Moreover, the activities of Redlands Hospital in effecting some
negligible degree of Medi-Cal coverage at the Surgery Center and
in increasing the number of managed care contracts do not provide
- 66 -
a basis for establishing petitioner's exemption. Cf. Harding
Hosp., Inc. v. United States, 505 F.2d 1068 (6th Cir. 1974)
(activities performed by third parties did not provide a basis
for organization’s exemption).
Petitioner asserts that the Surgery Center has no
requirement that patients demonstrate an ability to pay before
receiving treatment. The record does not reflect whether any
such policy has been communicated to its patients. Petitioner
suggests that this policy is evidenced by the Surgery Center’s
“substantial Medicare” patronage. The record shows that Medicare
accounted for 12 percent of invoices at the Surgery Center in the
last half of 1993. The record does not reflect, however, whether
the Surgery Center waives fees in excess of those covered by
Medicare and accordingly does not establish that ability to pay
is not a factor even for patients covered by Medicare. Moreover,
the Surgery Center’s treatment of Medicare patients cannot on
this record be attributed to petitioner’s influence over the
Surgery Center’s operations. According to the affidavit of Mr.
James R. Holmes, who was president of petitioner and Redlands
Hospital at the time of the affidavit, the Surgery Center “has
regularly treated Medicare patients * * * since before 1990.”
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c. Coordination of Activities of Redlands Hospital and
the Surgery Center
In arguing that it plays an active role in the conduct of
the Surgery Center’s activities, petitioner cites a number of
ways in which Redlands Hospital has integrated its activities
with those of the Surgery Center since the General Partnership
acquired its interest in the Operating Partnership. These
include Redlands Hospital’s use of the Surgery Center as a site
for training and surgeon proctoring, as well as various other
cooperative training and educational activities between Redlands
Hospital and the Surgery Center.19
Although there may be cooperation between the Surgery Center
and Redlands Hospital, nothing in the record suggests that these
various cooperative activities are more than incidental to the
for-profit orientation of the Surgery Center’s activities. Cf.
Harding Hosp., Inc. v. United States, supra at 1075-1076
19
The administrative record contains unexplained
inconsistencies regarding certain of these training procedures.
On the one hand, a letter in the administrative record, dated
Nov. 23, 1994, from Ernst & Young to respondent’s representative,
cites laproscopic cholecystectomy (gall bladder surgery) as an
example of a new procedure that Redlands Hospital was extensively
involved in teaching to physicians using the Surgery Center. On
the other hand, an affidavit of Gary J. Cottingham, president of
RHS and Redlands Hospital from Sept. 22, 1987, to May 12, 1995,
states that SCA Centers requested that the Surgery Center begin
to perform outpatient cholecystectomies at the Surgery Center,
but that the General Partnership’s managing directors rejected
the proposal. Mr. Cottingham’s affidavit states: “At least
through May 1995, * * * Outpatient cholecystectomies were not
performed at [the Surgery Center].”
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(educational, training and community-oriented programs conducted
at a hospital and funded by a third party were not sufficient to
merit the hospital’s tax exemption where other disqualifying
factors were present).
C. Competitive Restrictions and Market Advantages
By entering into the General Partnership agreement, RHS
(petitioner's parent corporation and predecessor in interest in
the General Partnership) not only acquired an interest in the
Surgery Center, but also restricted its future ability to provide
outpatient services at Redlands Hospital or elsewhere without the
approval of its for-profit partner. Paragraph 16 of the General
Partnership agreement, supra, prohibits the co-general partners
and their affiliates from owning, managing, or developing another
freestanding outpatient surgery center within 20 miles of the
Surgery Center, without the other partner’s consent. Moreover,
Redlands Hospital may not “expand or promote its present
outpatient surgery program within the Hospital.” In fact,
outpatient surgeries performed at Redlands Hospital decreased
about 17 percent from 1990 to 1995, while those performed at the
Surgery Center increased.
The General Partnership agreement also restricts the parties
and their affiliates from providing outpatient surgery services
and procedures that the agreement does not specifically authorize
to be provided at the Surgery Center (hereinafter referred to as
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nonlisted services). Under this agreement, Redlands Hospital,
but not the co-general partners or any of their other affiliates,
is allowed to perform nonlisted outpatient services that were
currently available to patients in California at the time the
General Partnership agreement was executed. By contrast, neither
Redlands Hospital nor the co-general partners or their affiliates
are allowed to perform nonlisted outpatient services that first
become available in California during the term of the General
Partnership agreement (i.e., until March 31, 2020), unless the
managing directors of the General Partnership approve.20
Consequently, RHS effectively restricted its own ability to
assess and service community needs for outpatient services until
the year 2020. It is difficult to conceive of a significant
charitable purpose that would be furthered by such a restriction.
The administrative record contains a market research report
on the ambulatory surgery center industry, prepared by Ernst &
Young and transmitted to Redlands Hospital on October 20, 1994.
This report describes the strong movement toward providing health
care services in ambulatory settings, driven both by economic
considerations and technological advances.21 The report notes
20
As previously discussed, petitioner lacks sufficient
control to dictate any such approval by the managing directors,
and, in the event of deadlock, the matter would go to
arbitration.
21
The report states that during the 1980's, hospital-based
(continued...)
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that hospitals face “strong competition” in this market. It
cites economic advantages that freestanding ambulatory surgery
centers enjoy over hospitals. These advantages include, among
other things, higher turn-over of operating rooms that increases
the number of “fee-generating procedures” surgeons can do; lower
nurse compensation that in turn leads to “higher margins”; and
the “general tendency for private payers to account for a high
percentage of a surgery center’s mix, since most procedures
performed in outpatient settings are elective (nonemergency) and
are done on younger, non-Medicare patients.” The report cites
physician relations and capital as two major barriers to entering
this market.
The Shearson Lehman Brothers investment summary, see supra
note 18, contains similar facts and conclusions. The report
indicates that SCA and Medical Care International are the two
main surgical center chains, that they are highly profitable, and
that their margins are likely to continue moving higher. The
report notes that one reason for the high profitability of these
chains is that “they typically shadow-price hospitals, which tend
21
(...continued)
outpatient surgeries grew from 3 million in 1980 to 11 million in
1990, and that nonhospital-based surgery volume increased even
faster, experiencing a 21.1-percent growth in procedures between
1989 and 1990 alone. The report projects continued growth in
this industry, stating: “The expansion of ambulatory surgery
service centers is likely to be accelerated by economic
incentives * * * as well as new technological developments.”
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to charge very high rates for outpatient surgery so they can
shift costs to the private sector and spread out their overhead.”
The report states that “one might expect hospitals to fight hard
for this business by starting up their own FASCs [freestanding
ambulatory surgery centers]”, but that this had not happened to
date because it is very hard for hospitals to do so, due partly
to problems hospitals face in throwing off their own “culture”
and creating an autonomous unit that is small, friendly, and
efficient. The report states: “[SCA’s] strategy of developing
three-way joint ventures--consisting of a local hospital,
surgeons, and the company--represents an attractive opportunity
to address these cultural problems.” The report notes:
the FASC niche of the health care services industry has the
further attraction of considerable consolidation
opportunity. We believe that multispecialty, nonhospital
FASCs currently number 600-700, with perhaps another 100
opening each year. Yet there are currently only two chains,
Medical Care International and [SCA] affiliates, which have
a total of 109 units. * * *
Once a surgical group decides to sell its center, there is
generally only one bidder (Medical Care or [SCA]), with the
price typically five to seven times pretax income. * * * The
key issue for MDs is not the modest amount of cash that
comes from a sale but the operating environment for them
once the center changes hands.
In the instant case, the Surgery Center had not one but two
bidders, the General Partnership, offering four to five times
earnings, and another unrelated, for-profit bidder, otherwise
unidentified in the record, offering approximately six times
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earnings. A letter from Ernst & Young to respondent’s
representatives, dated July 14, 1992, indicates that the Surgery
Center took the General Partnership’s offer instead of the other,
higher bid because of a desire to have an affiliation with
Redlands Hospital for quality control and other reasons.
Viewed in its totality, the administrative record is clear
that SCA and petitioner derive mutual economic benefits from the
General Partnership agreement. By borrowing necessary up-front
capital from SCA, RHS (petitioner's predecessor in interest in
the General Partnership), overcame a capital barrier to gain
entry into a profitable and growing market niche. By forming a
partnership with RHS, SCA Centers was able to benefit from the
established relationship between Redlands Hospital and the
limited partner physicians to acquire its interest in the Surgery
Center at a bargain price.
By virtue of this arrangement, petitioner and SCA Centers
realized further mutual benefits by eliminating sources of
potential competition for patients, as is evidenced by the
restrictions on either party’s providing future outpatient
services outside the Surgery Center, and by Redlands Hospital’s
agreeing not to expand or promote its existing outpatient surgery
facility at the hospital. In light of the statement in the
record that it is typical for national chains such as SCA to
“shadow-price” hospitals in charging for services at outpatient
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surgery centers, it seems most likely that one purpose and effect
of the containment and contraction of Redlands Hospital’s
outpatient surgery activities is to eliminate a competitive
constraint for setting Surgery Center fees (a matter delegated to
SCA Management under the management contract, excluding charges
for physicians’ services). Moreover, market consolidation
provided petitioner and SCA Centers mutual advantages by
eliminating pressures to compete in spending for expensive
equipment.22
There is no per se proscription against a nonprofit
organization's entering into contracts with private parties to
further its charitable purposes on mutually beneficial terms, so
long as the nonprofit organization does not thereby impermissibly
serve private interests. Cf. Plumstead Theatre Socy. v.
Commissioner, 75 F.2d 244 (9th Cir. 1982); Broadway Theatre
League v. United States, 293 F. Supp. 346 (W.D. Va. 1968). In
the instant case, however, RHS relied on the established
relationship between Redlands Hospital and Redlands physicians to
enable RHS and SCA affiliates jointly to gain foothold, on
favorable terms, in the Redlands ambulatory surgery market.
Then, by virtue of their effective control over the Surgery
22
As stated in a letter in the administrative record
written on behalf of petitioner from Ernst & Young LLP to
respondent, dated Nov. 23, 1994, “The Hospital and * * * [the
Surgery Center] also share surgical equipment so as to avoid a
‘medical arms race’ in the Redlands health care community.”
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Center, the SCA affiliates have been enabled to operate it as a
profit-making business, with significantly reduced competitive
pressures from Redlands Hospital, and largely unfettered by
charitable objectives that might conflict with purely commercial
objectives. Cf. est of Hawaii v. Commissioner, 71 T.C. 1067,
1080 (1979); Housing Pioneers, Inc. v. Commissioner, T.C. Memo.
1993-120, affd. 49 F.3d 1395 (9th Cir. 1995). The net result to
the SCA affiliates is a nonincidental "advantage; profit; fruit;
privilege; gain; [or] interest" that constitutes a prohibited
private benefit. See American Campaign Academy v. Commissioner,
92 T.C. 1053, 1065 (1989).
D. Conclusion
Based on all the facts and circumstances, we hold that
petitioner has not established that it operates exclusively for
exempt purposes within the meaning of section 501(c)(3). In
reaching this holding, we do not view any one factor as crucial,
but we have considered these factors in their totality: The lack
of any express or implied obligation of the for-profit interests
involved in petitioner's sole activity to put charitable
objectives ahead of noncharitable objectives; petitioner's lack
of voting control over the General Partnership; petitioner's lack
of other formal or informal control sufficient to ensure
furtherance of charitable purposes; the long-term contract giving
SCA Management control over day-to-day operations as well as a
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profit-maximizing incentive; and the market advantages and
competitive benefits secured by the SCA affiliates as the result
of this arrangement with petitioner. Taken in their totality,
these factors compel the conclusion that by ceding effective
control over its operations to for-profit parties, petitioner
impermissibly serves private interests.
IV. Petitioner’s Claim to Exemption Under
the Integral Part Doctrine
Petitioner argues that even if it does not qualify for tax
exemption on a “stand alone” basis, it qualifies for exemption
under the integral part doctrine.
The integral part doctrine is not codified, but rather is
the outgrowth of judicial opinions, rulings, and regulations.
The precise contours of this doctrine are not clearly defined.
The seminal case of Squire v. Students Book Corp., 191 F.2d 1018(9th Cir. 1951), held that an organization that operated a
bookstore on the premises of a college for the accommodation of
students and faculty was exempt because it bore a “close and
intimate relationship” to the functioning of the college itself.
See also Brundage v. Commissioner, 54 T.C. 1468 (1970); Estate of
Thayer v. Commissioner, 24 T.C. 384 (1955).
Shortly after the decision in Squire, Treasury regulations
acknowledged the existence of the integral part doctrine in
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providing an exception to the feeder organization rules under
section 502.23
Section 1.502-1(b), Income Tax Regs., provides as follows:
(b) If a subsidiary organization of a tax-exempt
organization would itself be exempt on the ground that its
activities are an integral part of the exempt activities of
the parent organization, its exemption will not be lost
because, as a matter of accounting between the two
organizations, the subsidiary derives a profit from its
dealings with its parent organization, for example, a
subsidiary organization which is operated for the sole
purpose of furnishing electric power used by its parent
organization, a tax-exempt educational organization, in
carrying on its educational activities. However, the
subsidiary organization is not exempt from tax if it is
operated for the primary purpose of carrying on a trade or
business which would be an unrelated trade or business (that
is, unrelated to exempt activities) if regularly carried on
by the parent organization. For example, if a subsidiary
organization is operated primarily for the purpose of
furnishing electric power to consumers other than its parent
organization (and the parent’s tax-exempt subsidiary
organizations), it is not exempt since such business would
be an unrelated trade or business if regularly carried on by
the parent organization. Similarly, if the organization is
owned by several unrelated exempt organizations, and is
operated for the purpose of furnishing electric power to
each of them, it is not exempt since such business would be
an unrelated trade or business if regularly carried on by
any one of the tax-exempt organizations. For purposes of
this paragraph, organizations are related only if they
consist of--
(1) A parent organization and one or more of its
subsidiary organizations; or
23
Although these regulations relate expressly to
determining whether an organization is a feeder organization
within the meaning of sec. 502 (an issue that respondent does not
raise in the instant case), this Court previously has referred to
these regulations in applying the integral part doctrine in the
context of sec. 501(c)(3) exemptions. See Geisinger Health Plan
v. Commissioner, 100 T.C. 394, 401 (1993), affd. 30 F.3d 494 (3d
Cir. 1994).
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(2) Subsidiary organizations having a common
parent organization. An exempt organization is not
related to another exempt organization merely
because they both engage in the same type of exempt
activities.
Since Squire, only a relatively small number of cases have
applied the integral part doctrine. These cases are fact-
specific. See Geisinger Health Plan v. Commissioner, 30 F.3d
494, 501 (3d Cir. 1994), affg. 100 T.C. 394 (1993), and cases
cited therein. As applied in a number of these cases, the
integral part doctrine requires the organization in question to
provide “necessary and indispensable” services solely to an
exempt organization to which it bears some legal or significant
operational relationship. See, e.g., Hospital Bureau of
Standards & Supplies, Inc. v. United States, 141 Ct. Cl. 91, 158
F. Supp. 560, 562 (1958) (recognizing exemption of an
organization that provided “necessary and indispensable” product
testing and purchasing of hospital supplies for its exempt member
hospital); University Med. Resident Servs., P.C. v. Commissioner,
T.C. Memo. 1996-251 (membership organizations that conducted
clinical training programs for member universities were not
exempt); Council for Bibliographic & Info. Techs. v.
Commissioner, T.C. Memo. 1992-364 (recognizing exemption of an
organization that conducted “necessary and indispensable”
activities for exempt member libraries). As applied in these
cases, the integral part doctrine operates to recognize a
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derivative exemption of an organization which serves only another
exempt organization and performs essential services that the
client organization otherwise would have performed for itself to
accomplish its own exempt purposes. See B.S.W. Group, Inc. v.
Commissioner, 70 T.C. 352, 360 (1978); University Med. Resident
Servs., P.C. v. Commissioner, supra, and cases cited therein.
Consistent with this rationale, professional group practices
serving exempt entities have been granted tax exemption under the
integral part doctrine. See University of Mass. Med. Sch. Group
Practice v. Commissioner, 74 T.C. 1299 (1980); B.H.W. Anesthesia
Found., Inc. v. Commissioner, 72 T.C. 681 (1979); University of
Md. Physicians, P.A. v. Commissioner, T.C. Memo. 1981-23. These
cases involved anesthesiology services or faculty medical
activities that were provided solely to the served hospital or
medical school and that were essential to the operation of the
hospital or medical school. See Geisinger Health Plan v.
Commissioner, 100 T.C. 394 (1993).
In Geisinger Health Plan v. Commissioner, supra, this Court
denied a claim for tax exemption asserted by an HMO under the
integral part theory. We reasoned that the group-practice line
of cases was not controlling because, unlike the exempt
organizations in those cases, the HMO had a population of
subscribers that did not overlap substantially with the patients
of the related exempt entities. In considering whether the HMO’S
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activities would have constituted an unrelated business if
conducted by its affiliate, we noted that section 513(a) defines
“unrelated trade or business” by reference to conduct that is
“not substantially related” to the organization’s exempt
functions. We stated that the determination whether conduct is
“substantially related” in this context “considers the degree to
which income is earned from services rendered or sales made to
persons who are not patients of the exempt affiliated entity.”
Id. at 405. Noting that entities related to the HMO provided 80
percent of the hospital services rendered to the HMO’s patients,
we held that the record in Geisinger did not justify a conclusion
as to whether the instances in which the HMO’s subscribers were
served by unrelated entities were substantial or insubstantial.
See id. at 406. Accordingly, we held that the HMO failed to
establish that its activities comprised an integral part of its
affiliate’s exempt activities.
Similarly, in the instant case, petitioner has failed to
establish that the Surgery Center’s patient population overlaps
substantially with that of Redlands Hospital. The record does
not reveal what percentage of persons served at the Surgery
Center are patients of Redlands Hospital. Clearly, however, the
Surgery Center was performing ambulatory surgery on a for-profit
basis for its own patients before petitioner was ever involved
and presumably continued to do so afterward.
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Even if we were to assume, arguendo, that the patient
populations of the Surgery Center and Redlands Hospital overlap
substantially, this circumstance would not suffice to confer
exemption on petitioner under the integral part doctrine. In all
the precedents cited above in which courts have applied the
integral part doctrine to recognize a derivative exemption, the
organization has been under the supervision or control of the
exempt affiliate (or a group of exempt affiliates with common
exempt purposes) or otherwise expressly limited in its purposes
to advancing the interests of the affiliated exempt entity or
entities, and serving no private interests.24 For instance, in
Squire v. Student Book Corp., 191 F.2d 1018, 1019 (9th Cir.
1951), all actions of the bookstore's board of trustees were
submitted to the president of the college for approval, and the
college comptroller acted as ex officio treasurer of the
bookstore. The bookstore paid no rebates and no part of its
earnings inured to private benefit. It seems clear that such
considerations are central to the court's holding in Squire that
24
In Geisinger Health Plan v. Commissioner, 100 T.C. 394,
402 (1993), affd. 30 F.3d 494 (3d Cir. 1994), we stated that the
parties had agreed that “an organization is entitled to exemption
as an integral part of a tax-exempt affiliate if its activities
are carried out under the supervision or control of an exempt
organization and could be carried out by the exempt organization
without constituting an unrelated trade or business” (emphasis
added). In Geisinger, we made a factual finding that the
affiliated exempt foundation controlled the HMO. See id. at 396.
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the bookstore's business enterprise “bears a close and intimate
relationship to the functioning of the College itself.”25
By contrast, as previously discussed, petitioner's sole
activity (the Surgery Center) is effectively controlled by for-
profit parties. The operations of the Surgery Center plainly are
not dedicated to advancing the interests of petitioner’s exempt
affiliates other than as those interests might happen to coincide
with the commercial interests of petitioner’s for-profit
25
See also University of Mass. Med. Sch. Group Practice v.
Commissioner, 74 T.C. 1299 (1980) (organization granted exemption
was created pursuant to a special act of the State legislature as
an integral part of the affiliated medical school and university
hospital); B.H.W. Anesthesia Found., Inc. v. Commissioner, 72
T.C. 681, 683 (1979) (organization granted exemption was the
incorporation of the affiliated hospital's department of
anesthesiology, and most control rested directly or indirectly
with the department's chairman); Brundage v. Commissioner, 54
T.C. 1468 (1970) (public museum that was determined to be an
integral part of the City of San Francisco’s city school system
had previously been conveyed to the city); Estate of Thayer v.
Commissioner, 24 T.C. 384 (1955) (alumni association’s activities
were for the purpose of advancing the affiliated public
university, which held possession of, administered, and invested
the association’s endowment fund, with no moneys used for the
benefit of any alumnus); University Med. Resident Servs., P.C. v.
Commissioner, T.C. Memo. 1996-251 (organizations’ memberships
consisted entirely of nonprofit schools and affiliated teaching
hospitals, representatives of which made all decisions about the
organizations’ activities); Council for Bibliographic & Info.
Techs. v. Commissioner, T.C. Memo. 1992-364 (organization’s
membership consisted entirely of public and academic libraries,
representatives of which comprised the organization’s board of
trustees); University of Md. Physicians, P.A. v. Commissioner,
T.C. Memo. 1981-23 (the organization's articles limited its
activities to serving the interests of the affiliated medical
school and hospital, and petitioner could not be used to serve
any private purpose of its stockholders); Hospital Bureau of
Standards & Supplies, Inc. v. United States, 141 Ct. Cl. 91, 158
F. Supp. 560, 562 (1958) (organization’s membership consisted
entirely of nonprofit hospitals).
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partners. Moreover, as previously discussed, petitioner
impermissibly serves private interests. Petitioner’s activity is
not so substantially and closely related to the exempt purposes
of its affiliates that these private interests may be
disregarded. See Geisinger Health Plan v. Commissioner, 100 T.C.
at 406, 407. Accordingly, petitioner is not entitled to
exemption under the integral part doctrine.
Remaining contentions not addressed herein we deem
irrelevant, without merit, or unnecessary to reach.
To reflect the foregoing,
Decision will be entered
for respondent.
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