PLR 1149042: IRS approved a health-care system reorganization and supporting-organization structure

Plain-English summary

The IRS ruled on a proposed reorganization of an integrated health-care system that included a pediatric hospital, medical organizations, supporting organizations, and a for-profit insurance company. A new parent corporation would become the sole corporate member of the affiliated organizations and sole shareholder of the insurance company, while the hospital’s community-based board would become the parent’s board. The IRS concluded that the organizations would continue to serve charitable health-care, medical education, and research purposes. It also ruled that the parent and an existing supporting organization would qualify as Type II supporting organizations and that the transfers would not jeopardize exemption, nonprivate-foundation status, or generate unrelated business taxable income. The ruling was conditioned on there being no material changes in the facts.

Ruling snapshot

• Question: Would the proposed health-care system reorganization preserve exemption and supporting-organization status?
• Outcome: approved
• Key authorities: IRC §§ 501, 170, 509, and 511 through 514; Treas. Reg. §§ 1.501(c)(3)-1 and 1.509(a)-4.

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION
Release Number: 201149042 Contact Person:
Release Date: 12/9/2011
Date: September 15, 2011 Identification Number:

Telephone Number:

Uniform Issue List:
501.03-11
509.00-00
511.00-00

Legend

R =
S =
T =
U =
V =
W =
X =
Y =
Z =

Employer Identification Number:

Dear

This is in response to your request for a ruling dated November 13, 2008 which was submitted
on behalf of R, T, U, V, W, X and Y. These organizations have requested a number of rulings
regarding the income tax consequences of a proposed corporate reorganization described
below. This letter will address the ruling requests of all the entities. Your ruling request was
amended by your letters dated August 11, 2011 and August 17, 2011.

Facts:

R is recognized as exempt under section 501(c)(3) of the Internal Revenue Code and classified
as an organization described in section 509(a)(1) and 170(b)(1)(A)(iii) of the Code. R operates
a pediatric hospital and provides related health care services, including certain adult services
such as maternity care, for the benefit of the public. R has an affiliation with S, a nationally
ranked medical school with which R conducts medical education activities and facilitates
medical research. S is recognized as exempt under section 501(c)(3) and classified as an
organization described in section 509(a)(1) and 170(b)(1)(A)(ii).

T is recognized as exempt under section 501(c)(3) of the Code and is classified as an
organization described in section 509(a)(3). R is the sole member of T and selects its
governing board. T currently has no operations, but, pending the rulings requested herein,
will operate as the parent corporation of R and its affiliated health care entities. T was
established to carry out the purposes of R.

U is recognized as exempt under section 501(c)(3) of the Code and classified as an
organization described in section 509(a)(3). R is the sole member of U and selects its
governing board. U holds and invests funds on behalf of R and its affiliated health care
entities.

V is recognized as exempt under section 501(c)(3) of the Code and classified as an
organization described in section 509(a)(2). V operates a health maintenance organization.

W is recognized as exempt under section 501(c)(3) of the Code and classified as an
organization described in section 509(a)(2). W employs pediatricians who provide medical care
to pediatric patients in R’s service area.

X is recognized as exempt under section 501(c)(3) of the Code and classified as an
organization described in section 509(a)(2). X employs obstetricians, gynecologists and
pediatric radiologists and provides services in support of pediatric specialists who are affiliated
with R.

Y is recognized as exempt under section 501(c)(3) of the Code and classified as an
organization described in section 509(a)(3). R is the sole member of Y and selects its
governing board. Y supports the provision of physician services in connection with obstetrical
and women’s services offered by R.

Z is a for-profit company which provides primary and excess professional malpractice and
general liability insurance coverage to R and its affiliated health care entities. All of the stock of
Z is owned by R.

Together, R, T, U, V, W, X, Y, and Z operate as an integrated health care delivery system,
providing a full range of pediatric and obstetrical services for the benefit of the public.

As the scope of services provided by R and its integrated health care delivery system has
expanded, the governing board of R has spent an increasing amount of time on strategic
planning and coordinating the various activities pursued under the umbrella of R’s integrated

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health care delivery system. After considering various organizational structures, the governing
board of R has concluded that the most efficient organizational structure is to place T in the
position of common parent of R, U, V, W, X, Y, and Z and pursue through T overall strategic
planning and coordination. Under the proposed reorganization, T will act as the parent
corporation of R, U, V, W, X, Y, and Z, providing overall strategic direction to assure that each is
working towards a common goal in a manner that is cost effective and coordinated to provide the
best possible medical care, medical education, and medical research for the benefit of the public.
This will serve the additional purpose of separating U, V, W, X, Y, and Z assets and earnings from
R’s assets and earnings, promoting a more efficient economic model, as well as a more efficient
governance model.

To effectuate the proposed reorganization, the Articles of Incorporation and bylaws of R, U, V, W,
X, and Y will be amended so that T will be designated the sole corporate member of each. As sole
corporate member, T will have the appointment and removal powers and reserved authority
currently held by R. Finally, all stock of Z will be transferred to T and T will exercise all rights and
powers in its status as sole shareholder. You provided copies of the proposed amended Articles
and bylaws for R, T, U, V, W, X and Y.

As the vehicle for strategic planning and coordination, T will facilitate overall executive
management, finance, legal, compliance, human resources, internal audit and other system-
wide functions. The community-based governing board of R will become the governing board of
T and continue to exercise overall control over R, U, V, W, X, Y, and Z. In the new
organizational structure the governing board of T can concentrate on strategic planning and
overall coordination of activities without the burden of operational oversight functions required to
be undertaken by the governing board of an operating hospital.

With the migration of the community-based governing board of R into the role of governing
board of T, the governing board of R will be restructured and reduced in size to reflect its
narrower role as the governing body of an operating hospital. As reorganized, the governing
board of R will operate in a manner similar to the governing boards of U, V, W, X, Y, and Z,
focusing primarily on the operational issues affecting R as it pursues the delivery of quality
health services, medical education and medical research. R and its affiliates believe that the
proposed reorganization will allow each member of R’s integrated health care delivery system to
pursue its mission in the most efficient manner, while enhancing strategic planning and
coordination.

After the proposed reorganization, two of the voting members of the board of directors of R will also
be members of the board of directors of T. In addition, each of the four key senior executive
management officers of R will serve as the four key senior executive management officers of T.
These common executive management officers include each organization's chief executive officer
and each organization's executive-vice presidents. T's Articles of Incorporation will be amended to
state that T was formed to benefit R and its affiliated organizations that are described in section
501(c)(3) of the Code and classified as organizations described in section 509(a)(1) or (2) of the
Code.

After the proposed reorganization, one of the voting members of the board of directors of R will
serve on the board of directors of U. R’s president and chief executive officer will serve as the
president and chief executive officer of U. In addition, R’s chief financial officer will serve as the

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chief financial officer of U. U’s Articles of Incorporation will be amended to state that U was formed
to benefit R and its affiliated organizations that are described in section 501(c)(3) of the Code and
classified as organizations described in section 509(a)(1) or (2) of the Code.

Rulings requested:

1. The proposed reorganization and resulting corporate structure will not result in the
   revocation of, or otherwise adversely affect, the continued status of R, T, U, V, W, X or Y
   as organizations described in section 501(c)(3) of the Code.

2. Any transfers of funds, assets, services and/or personnel in connection with the
   proposed reorganization will not jeopardize the continued status as an organization
   described in section 501(c)(3) of the Code of the organization providing such funds,
   assets, services and/or personnel.

3. Any transfers of funds, assets, services and/or personnel in connection with the
   proposed reorganization will not adversely affect the continued nonprivate foundation
   status of R, T, U, V, W or X under sections 509(a)(1), 509(a)(2) or 509(a)(3) of the
   Code, as applicable.

4. Any payments or transfers of funds, assets, services and/or personnel in connection with
   the proposed reorganization will not generate unrelated business taxable income under
   sections 511 through 514 of the Code.

5. Under the proposed reorganization, T and U will qualify as Type II supporting
   organizations under section 509(a)(3)(B)(ii) of the Code.

Law:

Section 501(c)(3) of the Code provides that organizations that are organized and operated
exclusively for religious, charitable, scientific or educational purposes are exempt from federal
income tax, so long as no part of their net earnings inures to the benefit of any private
shareholder or individual.

Section 1.501(c)(3)-1(d)(1) of the Income Tax Regulations provides, in pertinent part, that an
organization may be exempt as an organization described in section 501(c)(3) of the Code if it is
organized and operated exclusively for charitable purposes.

Section 1.501(c)(3)-1(d)(2) of the regulations provides that the term “charitable” is used in
section 501(c)(3) of the Code in its generally accepted legal sense.

In the general law of charity, the promotion of health is considered to be a charitable purpose.
Restatement (Second), Trusts, sec. 368 and sec. 372; IV Scott on Trusts (3rd ed. 1967), section
368 and sec. 372. A nonprofit organization whose purpose and activity are providing health
care is promoting health and may, therefore, qualify as organized and operated in furtherance of
a charitable purpose. If it meets the other requirements of section 501(c)(3) of the Code, it will
qualify for exemption from Federal income tax under section 501(a).

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Section 509(a) of the Code provides that the term “private foundation” means an organization
described in section 501(c)(3) other than certain organizations described in section 509(a)(1),
(2), (3) or (4).

Section 170(b)(1)(A)(iii) of the Code describes an organization the principal purpose or functions
of which are the providing of medical or hospital care or medical education or medical research.

Section 509(a)(2) of the Code describes, in pertinent part, organizations which normally receive
more than one-third of their support in gross receipts from the performance of services or
furnishing of facilities.

Section 509(a)(3) of the Code provides that the term “private foundation” does not include an
organization that:

(A) is organized and operated exclusively for the benefit of, to perform the functions of, or to
carry out the purposes of one or more organizations described in section 509(a)(1) or (2);

(B) is operated, supervised or controlled by, or in connection with, one or more organizations
described in section 509(a)(1) or (2);

(C) is not controlled, directly or indirectly, by one or more persons who would be disqualified
persons as defined in section 4946 if the organization were a private foundation, other than
foundation managers as defined in section 4946(a)(1)(B) and organizations described in section
509(a)(1) and (2).

Section 509(a)(3)(B) of the Code describes three relationships, one of which must be
established in order to satisfy the requirements of supporting organization status. One of
those relationships, referred to as the Type II relationship is described in section
509(a)(3)(B)(ii). Section 509(a)(3)(B)(ii) requires the supporting organization to be
“supervised or controlled in connection with” the supported organization.

Section 1.509(a)-4(h)(1) of the regulations provides that to qualify as a Type II supporting
organization, “the control or management of the supporting organization must be vested in
the same persons that control or manage the publicly supported organizations.” Such
persons need not necessarily be board members, but can hold other types of leadership
roles. See Example (3) of section 1.509(a)-4(h)(3).

Section 1.509(a)-4(d)(2) of the regulations provides, in pertinent part, that an organization that is
“supervised or controlled in connection with” a supported organization may designate the
publicly supported organizations it was formed to support by class or purpose.

Section 1.509(a)-4(e) of the regulations sets forth the operational test of section
509(a)(3)(A) of the Code. There are two parts to this test, the permissible beneficiaries
requirement and the permissible activities requirement. The permissible beneficiaries
requirement described at section 1.509(a)-4(e)(1) provides that a supporting organization
will be regarded as “operated exclusively” to support one or more specified publicly
supported organizations only if it engages solely in activities which support or benefit the
specified publicly supported organizations. An organization will be regarded as “operated

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exclusively” to support or benefit one or more specified publicly supported organizations
even if it supports or benefits an organization, other than a private foundation, which is
described in section 501(c)(3) and is operated, supervised, or controlled directly by or in
connection with such publicly supported organizations. The permissible activities
requirement of section 1.509(a)-4(e)(2) provides that an organization will not be regarded
as operated exclusively to support or benefit one or more specified publicly supported
organizations if any part of its activities is in furtherance of a purpose other than supporting
or benefiting one or more specified publicly supported organizations. All such support must
be limited to the permissible beneficiaries in accordance with section 1.509(a)-4(e)(1).

Section 1.509(a)-4(j) of the regulations provides that under the provisions of section
509(a)(3)(C) of the Code a supporting organization may not be controlled directly or
indirectly by one or more disqualified persons (as defined in section 4946) other than
foundation managers and other than one or more publicly supported organizations.

Section 511(a) of the Code imposes a tax on the unrelated business income of organizations
described in section 501(c).

Section 512(a)(1) of the Code defines “unrelated business taxable income” as the gross income
derived by an organization from any unrelated trade or business regularly carried on by it, less
the allowable deductions that are directly connected with the carrying on of the trade or business,
with certain modifications. Section 1.513-1(b) of the regulations provides that the phrase “trade
or business” includes activities carried on for the production of income and that possess the
characteristics of a trade or business within the meaning of section 162 of the Code. Finally,
section 1.501-1(c) of the regulations explains that “regularly carried on” refers to the frequency
and continuity of the conduct of an activity and the manner in which the activity is pursued.

Section 513(a) of the Code defines an “unrelated trade or business” as any trade or business
the conduct of which is not substantially related (aside from the need of the organization for
funds or the use it makes of the profits derived) to the exercise of the organization's exempt
purposes or functions.

Section 1.513-1(d)(2) of the regulations provides, in part, that a trade or business is related to
exempt purposes only where the conduct of the business activities has a causal relationship to
the achievement of exempt purposes; and it is substantially related for purposes of section 513
of the Code only if the causal relationship is a substantial one. Thus, for the conduct of a
trade or business from which a particular amount of gross income is derived to be substantially
related to purposes for which exemption is granted, the production or distribution of goods or
the performance of the services from which the gross income is derived must contribute
importantly to the accomplishment of exempt purposes.

Rev. Rul. 60-143, 1960-1 C.B. 192 held that an alumni association whose major activities
are participating in a university's fund raising campaigns and performing necessary
services for the university qualifies for exemption under section 501(c)(3) of the Code
where the association is controlled by or operated as an integral part of an educational
institution or otherwise shows a substantial integration with such an institution.

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Rev. Rul. 69-545, 1969-1 C.B. 117 describes the standards under which a nonprofit hospital may
qualify for recognition of exemption under section 501(c)(3) of the Code. The revenue ruling
considered two separate hospitals, only one of which was determined to qualify for exempt status
under section 501(c)(3). By weighing all the relevant facts and circumstances, the revenue ruling
analyzed whether both the control and use of the hospitals were for the benefit of the public or
the benefit of private interests.

Rev. Rul. 77-72, 1977-1 C.B. 157 held that if participating exempt organizations are in an
affiliated system or are organizations subject to common control, then corporate services
provided between them necessary to their being able to accomplish their exempt purposes
are treated as other than an unrelated trade or business and the financial arrangements
between them are viewed as merely a matter of accounting.

Analysis:

The proposed reorganization will enable R and its affiliated organizations to broaden and
diversify their services and achieve administrative efficiencies while furthering R's primary goal
and mission to support pediatric and adult patient care, medical education and medical research
with a commitment to quality service, and cost-effective care to enhance the health and well-being
of children locally, nationally and internationally. R anticipates that the reorganization will
enhance its ability to more efficiently structure its varied operations and strategically plan for
the future of its integrated health care delivery system. Ultimately, the reorganization will allow
R and its affiliates to provide a broader range of services to the general public while continually
improving the overall quality of health care provided.

In conjunction with the proposed reorganization, the Articles of Incorporation and bylaws of
the organizational test with respect to section 501(c)(3) of the Code.

After the proposed reorganization, R, V, W, and X will continue to provide health care
services to the community in the manner described in Rev. Rul. 69-545, supra. See also
Restatement (Second), Trusts, sec. 368 and sec. 372; IV Scott on Trusts (3rd ed. 1967), section
368 and sec. 372. T, U and Y will engage primarily in activities which support R’s charitable
purpose. See Rev. Rul. 60-143, supra. The only significant structural changes resulting from
the reorganization will be T’s replacement of R as the sole corporate member of U, V, W, X, and
Y, the addition of T as the sole corporate member of R, and T’s replacement of R as the sole
shareholder of Z. With R’s community based governing board becoming the governing board of
T, overall control of the integrated health care delivery system will rest in the same persons who
currently exercise such control, assuring uninterrupted pursuit of charitable goals by R and its
affiliates.

R has been recognized as an organization described in section 509(a)(1) and 170(b)(1)(A)(iii) of
the Code. After the proposed reorganization, R will continue to operate as a hospital described
in section 170(b)(1)(A)(iii).

V, W and X have been recognized as organizations described in section 509(a)(2) of the Code.
Section 509(a)(2) of the Code describes organizations supported by fees from the provision of

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services and facilities. After the proposed reorganization, V, W and X will continue to provide
health care services and will be supported by related fees.

T has been recognized as an organization described in section 509(a)(3) of the Code. After
the proposed reorganization, T will continue to meet the organizational test set forth in
section 1.509(a)-4(c) of the regulations because its proposed amended Articles of
Incorporation limit its purposes to one or more of the purposes set forth in section
509(a)(3)(A) of the Code; do not expressly empower T to engage in activities that do not
further such purposes; specify R and its affiliated organizations that are described in section
501(c)(3) of the Code and classified as organizations described in section 509(a)(1) or (2) of the
Code as T’s supported organizations; and do not expressly empower T to operate to support
or benefit any organization other than the specified publicly supported organizations.

To meet the operational test described at section 1.509(a)-4(e) of the regulations, T must
engage solely in activities which support or benefit the publicly supported organizations
specified in its proposed amended Articles of Incorporation. However, T may support or
benefit organizations other than those specified in its Articles if such organizations are
permissible beneficiaries. See section 1.509(a)-4(e)(1).

After the proposed reorganization, T will meet the operational test since it will engage in
activities that support or benefit R, V, W, and X. See section 1.509(a)-4(e)(2) of the
regulations. R, V, W, and X are identified by name or class as supported organizations in
T’s proposed amended Articles of Incorporation. In addition, T may engage in activities that
support or benefit U, an organization described in section 509(a)(3) of the Code. Since U is
“supervised or controlled in connection with” R, U is a permissible beneficiary as defined at
section 1.509(a)-4(e)(1).

After the proposed reorganization, two of the voting members of the board of directors of R will also
be members of the board of directors of T. In addition, each of the four key senior executive
management officers of R will serve as the four key senior executive management officers of T.
These common executive management officers include each organization’s chief executive officer
and each organization's executive-vice presidents. Thus, T will be “supervised or controlled in
connection with” R, within the meaning of section 1.509(a)-4(h) of the regulations.

After the proposed reorganization, T will not be controlled directly or indirectly by one or
more disqualified persons (as defined in section 4946) other than foundation managers and
other than one or more publicly supported organizations. See section 1.509(a)-4(j) of the
regulations.

U has been recognized as an organization described in section 509(a)(3) of the Code. After
the proposed reorganization, U will continue to meet the “organizational test” set forth in
section 1.509(a)-4(c) of the regulations because its proposed amended Articles of
Incorporation limit its purposes to one or more of the purposes set forth in section
509(a)(3)(A) of the Code; do not expressly empower U to engage in activities that do not
further such purposes; specify R and its affiliated organizations that are described in section
501(c)(3) of the Code and classified as organizations described in section 509(a)(1) or (2) of the
Code as U’s supported organizations; and do not expressly empower U to operate to support
or benefit any organization other than the specified publicly supported organizations.

To meet the operational test described at section 1.509(a)-4(e) of the regulations, U must
engage solely in activities which support or benefit the publicly supported organizations
specified in its proposed amended Articles of Incorporation. However, U may support or
benefit organizations other than those specified in its Articles if such organizations are
permissible beneficiaries. See section 1.509(a)-4(e)(1).

After the proposed reorganization, U will meet the operational test since it will engage in
activities that support or benefit R, V, W, and X. See section 1.509(a)-4(e)(2) of the
regulations. R, V, W, and X are identified by name or class as supported organizations in U's
proposed amended Articles of Incorporation. In addition, U may engage in activities that
support or benefit T, an organization described in section 509(a)(3) of the Code. Since T is
“supervised or controlled in connection with” R, T is a permissible beneficiary as defined at
section 1.509(a)-4(e)(1).

After the proposed reorganization, one of the voting members of the board of directors of R will
serve on the board of directors of U. R’s president and chief executive officer will serve as the
president and chief executive officer of U. In addition, R’s chief financial officer will serve as the
chief financial officer of U. Thus, U will be “supervised or controlled in connection with” R,
within the meaning of section 1.509(a)-4(h) of the regulations.

After the proposed reorganization, U will not be controlled directly or indirectly by one or
more disqualified persons (as defined in section 4946) other than foundation managers and
other than one or more publicly supported organizations. See section 1.509(a)-4(j) of the
regulations.

Rev. Rul. 77-72, supra., held that if participating exempt organizations are in an affiliated
system or are organizations subject to common control, then corporate services provided
between them necessary to their being able to accomplish their exempt purposes are treated
as other than an unrelated trade or business and the financial arrangements between them
are viewed as merely a matter of accounting. Like the organizations described in Rev. Rul.
77-72, R, T, U, V, W, X and Y are part of an affiliated system subject to common control. The
transfer of assets, funds, services and/or personnel which will occur as a result of the proposed
reorganization are necessary to their being able to accomplish their exempt purposes under
section 501(c)(3) of the Code.

Based on the information furnished, we rule that:

1. The proposed reorganization and resulting corporate structure will not result in the
   revocation of, or otherwise adversely affect, the continued status of R, T, U, V, W, X or Y
   as organizations described in section 501(c)(3) of the Code.

2. Any transfers of funds, assets, services and/or personnel in connection with the
   proposed reorganization will not jeopardize the continued status as an organization
   described in section 501(c)(3) of the organization providing such funds, assets,
   services and/or personnel.

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3. Any transfers of funds, assets, services and/or personnel in connection with the
   proposed reorganization will not adversely affect the continued nonprivate foundation
   status of R, T, U, V, W or X under sections 509(a)(1), 509(a)(2) or 509(a)(3) of the
   Code, as applicable.

4. Any payments or transfers of funds, assets, services and/or personnel in connection with
   the proposed reorganization will not generate unrelated business taxable income under
   sections 511 through 514 of the Code.

5. Under the proposed reorganization, T and U will qualify as Type II supporting
   organizations under section 509(a)(3)(B)(ii) of the Code.

This ruling is based on the understanding that there will be no material changes in the facts
upon which it is based.

We express no opinion as to the tax consequences of the proposed transaction under any other
section of the Code.

Pursuant to a Power of Attorney on file in this office, a copy of this letter is being sent to your
authorized representative. A copy of this letter should be kept in its permanent records.

This ruling is directed only to the organization that requested it. Section 6110(k)(3) of the Code
provides that it may not be used or cited by others as precedent.

If there are any questions about this ruling, please contact the person whose name and
telephone number are shown in the heading of this letter.

Sincerely,

Theodore R. Lieber
Manager, Exempt Organizations
Technical Group 3

Enclosure
Notice 437