IRS denies social-welfare exemption to nonprofit HMO

View official IRS release (PDF)

Plain-English summary

A proposed nonprofit health maintenance organization planned to acquire and continue the business of a for-profit HMO while remaining controlled by an affiliated academic health system. Nearly all projected revenue would come from subscriber premiums, most subscribers would receive coverage through employer group plans, and the identified social-welfare programs represented only about 1% of projected expenditures. The IRS found that the HMO primarily arranged healthcare for paying subscribers rather than promoting the common good of the community. It also found that the HMO was not an integral part of the affiliated health system because it served a broader population, used providers outside that system, and supplied no necessary service exclusively to its exempt affiliates. The IRS therefore denied exemption under § 501(c)(4), and the applicant later withdrew its protest.

Ruling snapshot

• Question: Did the proposed nonprofit HMO qualify under § 501(c)(4) through its own social-welfare activities or as an integral part of an exempt academic health system?
• Outcome: Denied
• Key authorities: IRC §§ 501(a), 501(c)(4), and 502; Treas. Reg. §§ 1.501(c)(4)-1, 1.502-1(b)

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION

Release Number: 201451033
Release Date: 12/19/2014
Date: September 24, 2014

UIL:

501.00-00
501.04-00
501.04-02

Dear

This is our final determination that you do not qualify for exemption from Federal income tax under Internal Revenue Code section 501(a) as an organization described in Code section 501(c)(4).

We made this determination for the following reason(s): You are not operated exclusively for promotion of social welfare within the meaning of § 501(c)(4).

You protested our proposed adverse ruling; however, you subsequently withdrew your protest. At the time that you withdrew your protest, we notified you of the opportunity to have your case reviewed by the Office of Appeals and gave you 30 days to request referral of your case to the Office of Appeals. As we did not receive a request to transfer your case to Office of Appeals within the requisite 30 days, the proposed adverse ruling is now final.

You must file Federal income tax returns on the form and for the years listed above within 30 days of this letter, unless you request an extension of time to file. File the returns in accordance with their instructions, and do not send them to this office. Failure to file the returns timely may result in a penalty.

We will make this letter and our proposed adverse determination letter available for public inspection under Code section 6110, after deleting certain identifying information. Please read the enclosed Notice 437, Notice of Intention to Disclose, and review the two attached letters that show our proposed deletions. If you disagree with our proposed deletions, follow the instructions in Notice 437. If you agree with our deletions, you do not need to take any further action.

If you have any questions about this letter, please contact the person whose name and telephone number are shown in the heading of this letter. If you have any questions about your Federal income tax status and responsibilities, please contact IRS Customer Service at

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1-800-829-1040 or the IRS Customer Service number for businesses, 1-800-829-4933. The IRS Customer Service number for people with hearing impairments is 1-800-829-4059.

Sincerely,

Matthew A. Weir
Director, Exempt Organizations
Rulings and Agreements

Enclosure
Notice 437
Redacted Proposed Adverse Determination Letter
Redacted Final Adverse Determination Letter

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

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Uniform Issue List Numbers: December 5, 2013
501.00-00
501.04-00
501.04-02

Legend

A =
Parent =
Faculty Practice =
Exchange =
F =
G =
Hospital =
Medical School =
Nursing School =
ACO =
Q =
R =
S =
T =
County =
State =
Year 1 =
Year 2 =
Year 3 =
Year 4 =
Year 5 =
Year 6 =
Year 7 =
Year 8 =
$100x =
$100y =

Dear
This letter supersedes our letter dated December 2, 2013.

We have considered your application for recognition of exemption from Federal income tax under Internal Revenue Code section 501(a). Based on the information provided, we have

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concluded that you do not qualify for exemption under Code section 501(c)(4). The bases for our conclusion are set forth below.

Facts

Formation and History

You filed Articles of Incorporation under State statutes pertaining to nonprofit insurance corporations. Your Articles of Incorporation provide that you were created exclusively to promote social welfare “by offering prepaid health care services that support the missions of research, education, community service and clinical expertise of A to the people of State and beyond by operation of a health maintenance organization and other activities incidental thereto... .”

You are a new corporation that will acquire the assets and assume the business of F by merging with F, and leaving you as the surviving entity.

F was formed in Year 1 as a for-profit HMO. Parent acquired F in Year 2. Parent will continue to control you, except that, after your merger with F, instead of holding shares in F, Parent will be your sole member.

A is an affiliated group of healthcare entities. Your relationship to other components of A can be graphically represented as follows:

Medical School Faculty Practice Hospital
Parent
ACO
You

Parent is a membership organization that is exempt under § 501(c)(3). Parent has the following three members:

• Medical School (a governmental unit within the meaning of § 170(b)(1)(v) and
  § 170(c)(1))

• Faculty Practice (an organization described in § 501(c)(3))

• Hospital (a public corporation which the State legislature created. It is also
  recognized as an organization described in § 501(c)(3))

A operates a medical school, clinics and hospitals in County. F serves a 20-county area in southern State, which includes County. F’s subscribers have access to over 50 hospitals and clinics in the 20-county service area. You will assume and maintain F’s service area and provider network.

Management

You have a seven-member Board of Directors. Hospital appoints three directors. Faculty Practice appoints two directors. An unrelated Federally Qualified Health Center, within the

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meaning of Section 330 of the Public Health Service Act (42 USCS § 254b), appoints one director. Parent appoints one director from the community at large.

Your president will concurrently serve as an officer of Faculty Practice and will devote 90 percent of his or her time to duties performed for you, and 10 percent to duties performed for Faculty Practice. You and Faculty Practice will share the president's compensation ratably.

Your officers will be compensated for their services in accordance with policies and procedures employed by A and its constituent entities. Other than the president, who divides his or her time as described above, you will exclusively employ your other officers. They will not receive compensation from any other constituent of A.

Your Activities

Healthcare Plans

You will continue the business of F. In addition, you will offer healthcare plans through the Exchange (which implements the health insurance exchanges under Patient Protection and Affordable Care Act, P.L. 111-148, as amended (“ACA”)). Your healthcare plans will be available to subscribers residing throughout the existing 20- county area served by F.

You allocated your estimated healthcare revenue for Year 3 among the following healthcare plans:

Table 1
Plan Revenues
HMO $ x
Preferred Provider Organization Plans $ x
Point of Service Plans $ x
Medicare Select <$ x
Medicaid $ x
Total: $ x
You also described the allocation of F’s subscribers as follows: Table 2 Type of Subscriber Share Subscribers under employer provided group plans % State and local government/school districts - % For-profit employer - % Not-for profit employer - % Individual (non-group) subscribers % Medicaid-eligible subscribers % Medicare supplement subscribers % Total: %

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You further explained that you anticipate some reallocation among your plan offerings when the ACA takes effect in Year 4 and individuals begin purchasing plans through the Exchange. You described the anticipated allocation of your subscribers after implementation of the ACA as follows:

Table 3
Subscribers Year 5 | Year 6 | Year 7 | Year 8
Subscribers under employer provided group % % % %
plans*
Subscribers to individual plans sold through % % % %
the Exchange — not qualifying for a subsidy
Low-income subscribers to individual plans % % % %
sold through the Exchange — qualifying for a
subsidy
Medicaid-eligible subscribers % % % %
Medicare supplement subscribers % % % %

% % % %

• No distinction is made among HMO, PPO and POS plans.

Your specific activities in connection with the administration of your healthcare plans will include the following:

i. Arranging for prepaid healthcare services for subscribers through employer group plans and individual policies.

ii. Arranging for healthcare services to be provided to subscribers through Point of Service (“POS”) and Preferred Provider Organization (“PPO”) plans.

iii. Arranging for healthcare services to be provided to subscribers eligible for public health care assistance through programs administered by T (Medicaid plans).

iv. Arranging for medical services to be provided to subscribers through the Exchange.

v. Monitoring effectiveness of delivery of services by contracting healthcare providers using the Healthcare Effectiveness Data and Information Set to measure performance by healthcare providers and using the Consumer Assessment of Health Providers & Systems to measure patients’ and families’ satisfaction with healthcare provided.

vi. Designing and implementing pay-for-performance incentives with primary care providers.

You will continue to contract with medical service providers and facilities in A’s service area (in County), as well as the remaining 19 counties of F’s service area outside of County. In addition to your contracts with facilities and providers affiliated with A, you will enter into agreements to arrange for healthcare services to be provided by over 50 hospitals, over 800 primary care providers and over 1,500 specialty providers. You estimated that approximately 70 percent of your subscribers will reside within County,

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with your remaining subscribers residing in the 19-counties you will serve that are outside the A service area.

Social Welfare Activities

The specific social welfare activities that you will undertake including the following:

Providing financial assistance to individuals and families who qualify for coverage through the Exchange, but who are unable to afford the premiums.

Because federal regulations prohibit you from providing direct subsidies to qualifying subscribers through the Exchange, you will provide grant funds to S. S will use those funds to provide subsidies to qualifying individual subscribers through the Exchange, without regard to the provider chosen by the recipient of the subsidy. Making grants for the following purposes:

(1) Population health research.

(2) Support of a Federally Qualified Health Center and other community organizations.

(3) Capital projects and programs at Medical School and Nursing School.

Hosting mammography screening events open to women ages 40 to 69 and similar wellness events.

Providing access to “clinically based education materials,” some or all of which will be available to the general public through your website.

G, a division internal to you, will administer your social welfare activities.

Other Activities

You will share health information that you obtain regarding your subscribers with R. R is a data warehousing initiative that A formed. You will use the data warehouse for your own purposes, and accordingly you will bear a proportionate share of the operating expenses related to the administration, maintenance, and development of the data warehouse. In addition, because data relating to your subscribers will reside in the data warehouse, that data is available to researchers and clinicians affiliated with R.

F uses the same data warehouse as other entities affiliated with A. F is the only payor whose core healthcare plan processing system resides within the same electronic health

record system as A uses. This connection facilitates delivery of data derived from F subscribers to Medical School for use in its academic mission, and to clinical faculty for use in their research. However, you disclose that the electronic health record system from which Medical School derives health data for clinical and research purposes also receives data from payors other than F, indicating that Faculty Practice obtains health

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data from many external sources. Supporting information provided by Medical School specifically states that the electronic health records system that Medical School uses does not differentiate among patients based upon their payors. The patient data and “de-identified data” from F subscribers comprises a fraction of the data available to Medical School for clinical and research purposes.

You will provide financial support to Q through G. Q is conducted within Medical School. The goal of Q is to design, implement, and evaluate strategies to improve health care delivery. Q obtains data about the Medicare population from the Centers for Medicare Services (“CMS”). Information that you provide broadens the pool of data available to Q to include your private paying subscribers, as well as your Medicaid subscribers.

You will contribute to the education of students of Medical School because a portion of your subscribers will obtain primary, specialty or in-patient care at facilities affiliated with A. In addition, you make grants to Medical School. Your financial contribution is coordinated through G.

We asked you to provide examples of marketing materials you would use to solicit subscribers. You stated that such materials are not currently available.

Contractual Relationships among Entities Affiliated with A

You state that, in the years since F was acquired by Parent, F has integrated its “mission, management philosophy and approach to community health care in an effort to become part of a fully integrated health care delivery system.” When you merge with F, you will enter into a broad range of contractual agreements with entities affiliated with A. In general, most of the contracts relate to administrative services that A provides to you to arrange for services to be provided to your subscribers. The contracts with affiliates of A are based upon cost and are not designed to generate a profit for either contracting party. You describe various ways in which your activities intersect with those of entities affiliated with A. For example, your medical director, two associate medical directors, and your director of health services will be shared with Faculty Practice or Hospital. Each person’s compensation will be allocated ratably between you and the affiliate of A to which the individual devotes his or her remaining time, in accordance with administrative services agreements between you and the applicable affiliate of A.

You contract with Faculty Practice for medical management services. You state that contracting for medical management services from Faculty Practice, instead of having those decisions made by one of your direct employees, makes you similar to a tax-exempt staff model HMO. You further state that you contract with Hospital to provide pharmacy management services. You state that this operational model benefits subscribers because pharmacy services provided to your subscribers are founded on “the evidence based practice of medicine and sound clinical decisions.” In addition, pharmacy data relating to your subscribers is shared with other components of A for research purposes.

Your Anticipated Revenues and Expenditures

You state that substantially all of your revenues will be from premiums charged to

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subscribers of your healthcare plans. You estimate your revenues from healthcare plans for

the periods below as follows:

Table 4
Year 3 Year 4
Healthcare plan revenues $ x $ y
Investment income <$ x <$ y
Total: ~$ x ~$ y

The allocation of premiums among different healthcare plans, and the expected shift of that allocation subsequent to the implementation of ACA are shown in Table 3 above.

You allocated your anticipated expenditures across the following categories:

Table 5

Expenditures

Percent

Healthcare provided to subscribers under employer-provided group plans

%

Healthcare provided to individual subscribers

%

Healthcare provided to Medicaid subscribers

%

Healthcare provided to Medicare Supplemental Plan
subscribers

%

Programs administered through G

%

Broker commissions

%

Other business expenses

%

Total:

%

Law

Social Welfare Organizations

Section 501(a) of the Code provides that an organization described in § 501(c) will be exempt

from taxation unless exemption is denied under §§ 502 or 503.

Section 501(c)(4)(A) describes “civic leagues or organizations not organized for profit but

operated exclusively for the promotion of social welfare.”

Section 1.501(c)(4)-1(a) of the Income Tax Regulations states:

(1) In general. A civic league or organization may be exempt as an organization

described in section 501(c)(4) if -

(i) It is not organized or operated for profit; and

(ii) It is operated exclusively for the promotion of social welfare.

(2) Promotion of social welfare.

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(i) In general. An organization is operated exclusively for the promotion of social welfare if it is primarily engaged in promoting in some way the common good and general welfare of the people of the community. An organization embraced within this section is one which is operated

primarily for the purpose of bringing about civic betterments and social improvements. .. .

(ii)... Nor is an organization operated primarily for the promotion of social welfare if its primary activity is . . . carrying on a business with the general public in a manner similar to organizations which are operated for profit.

Rev. Rul. 54-394, 1954-2 C.B. 131, describes an organization whose sole activity was to provide television reception for its members on a cooperative basis in an area not readily adaptable to ordinary reception. Members of the organization paid service and installation fees. Nonmember households could not derive any benefit from the organization’s activities. In concluding that the organization did not qualify for exemption under § 501(c)(4), the Revenue Ruling explained as follows:

When an organization’s only activity is to provide television reception on a cooperative basis to its members, who contract and pay for such services, such organization is held to operate for the benefit of its members rather than for the promotion of the welfare of mankind.

Rev. Rul. 62-167, 1962-2 C.B. 142, describes an organization created for the purpose of constructing and maintaining a reflector-type television station, capable of receiving signals of television stations and reproducing the signals, so that satisfactory television reception would be available to the community at large. All persons in the community could become members. The organization derived its revenues from a combination of membership fees and donations. The reflector-type equipment received signals from three television stations and retransmitted the signals into the community. Any television in the community could receive the signals retransmitted by the organization’s equipment. The organization in this Revenue Ruling is distinguishable from the organization described in Rev. Rul. 54-394. In the earlier Revenue Ruling, only members who entered into a contract with that organization and paid installation and service fees could access its services. In contrast, the organization described in this Revenue Ruling operated its system for the benefit of the community at large. Members paid a fee or made donations to this organization voluntarily. The same benefits could be enjoyed by members of the community who opt not to pay the membership fee. Accordingly, the organization described in this Revenue Ruling qualified for exemption under § 501(c)(4).

Rev. Rul. 73-349, 1973-2 C.B. 179, describes an organization formed to purchase groceries for its members at the lowest possible prices. Membership was open to the entire community; however, the benefits of the organization were available only to members. Each member paid a ratable share of the organization's administrative expenses. The organization was held not to qualify for exemption under § 501(c)(4) because it was “operated primarily for the private benefit of members and any benefits to the community [were] not sufficient to meet the requirement of the regulations that the organization be operated primarily for the common good and general

welfare of the people of the community.

Rev. Rul. 75-199, 1975-1 C.B. 160, describes an organization that provided sick benefits for its members and paid death benefits to the beneficiaries of deceased members. The organization restricted membership to individuals of good moral character and health who belonged to a particular ethnic group and who resided in a specific geographical area. The organization held monthly meetings and maintained an established system for the payment of sick and death benefits. Revenues were derived primarily from membership dues, which were used to pay benefits to members and to pay miscellaneous operating expenses. In concluding that the organization did not qualify for exemption under § 501(c)(4), the Revenue Ruling found that the organization was principally a mutual, self-interest organization that used its income to provide direct economic benefits to members. Any benefit to the community at large was minor and incidental.

Rev. Rul. 78-69, 1978-1 C.B. 136, describes an organization created by residents of a suburban community to provide bus transportation during rush hours between the community and the major employment centers in the metropolitan area. During rush hour periods, regular bus service was inadequate. The organization contracted for buses and drivers, planned their routes and schedules and arranged for volunteers to collect the fares on each trip. Although anyone could ride the organization’s buses for the established fare, ridership was drawn almost entirely from the community. Revenues from fares sometimes fell short of the amount needed to cover the organization’s expenses. The organization covered the short-fall through grants from governmental units. The organization was found to provide a useful service to all members of the community. The organization provided bus service to the area that was not otherwise commercially available, and paid for the service through fares and subsidies from governmental units. Access to the organization’s bus service was available to anyone and community residents and volunteers assist the organization to carry out its activities. This method of operation distinguished the organization from commercial bus services that carried on business with the public and operated for profit. As a result, because the organization promoted the common good and general welfare of the community, the organization qualified for exemption under § 501(c)(4).

Rev. Rul. 81-58, 1981-1 C.B. 331, describes a membership organization formed to benefit police officers in a community. The organization supplemented civil service retirement and death benefits provided by the political subdivision in which the police officers were employed. Benefits were limited to members (or their beneficiaries). The organization’s income was used to provide direct economic benefits to members. Therefore, although the class of employees benefited by the organization consisted of police officers engaged in the performance of essential and hazardous public services, the organization was principally “a mutual, self-interest type of organization” that provided only an incidental benefit to the larger community. Accordingly, the organization did not qualify for exemption as a social welfare organization under § 501(c)(4).

In Christian Echoes Nat'l. Ministry v. U.S., 470 F.2d 849 (10th Cir. 1972), cert. denied, 414 U.S. 864 (1973), citing Dickinson v. U.S., 346 U.S. 389 (1953), the court held that an organization claiming exemption must bear the burden of establishing its entitlement to exempt status.

Commissioner v. Lake Forest Inc., 305 F.2d 814 (4th Cir. 1962), denied exemption under

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§ 501(c)(4) to a nonprofit membership corporation that purchased two multi-family housing projects (consisting of over 500 residential units) from the federal government. The organization made units available to its members under perpetual-use contracts. Preference for membership was granted to inadequately housed veterans of World War lI (first) and veterans of World War I (second). However, in the absence of purchasers in these categories, the organization could sell perpetual-use contracts to other individuals approved by the organization.

The Court of Appeals held that the organization failed to qualify for exemption under § 501(c)(4) because its activities did not meet the dictionary definition of “civic.” Even though the benefits provided by the organization were “available to all citizens eligible for membership, the benefits were not municipal or public in nature.” The Court of Appeals also concluded that the organization failed to fall within the dictionary definition of “social” or “welfare,” because the organization “did not propose to offer a service or program for the direct betterment or improvement of the community as a whole.” Members, and not the public, derived a substantial private benefit from their purchase of perpetual-use contracts, including the right to the equitable ownership of the value of their units and the ability to pass the perpetual use contracts to family members at death.

In People’s Educational Camp Society, Inc. v. Commissioner, 39 T.C. 756 (1963), aff'd, 331 F.2d 923 (2nd Cir. 1964), the Tax Court affirmed revocation of the exempt status of an organization that was created to acquire real property where the organization would conduct studies and develop certain liberal and progressive social programs. The organization initially engaged in activities that promoted social welfare within the meaning of § 501(c)(4) and was recognized as exempt from tax. However, some years after its formation, the organization opened the premises to the public and commenced to operate a financially lucrative vacation resort that competed with for-profit resorts. The organization continued to engage in the activities that provided the basis for its exempt status; however, by the time that the organization’s exemption was revoked, the organization expended less than 2 percent of its revenues on the conduct of its exempt activities. Furthermore, in the context of the resort operations, various art and educational programming that originally furthered the organization’s exempt purpose had, over time, acquired entertainment value that enhanced the commercial resort function. When considered in relation to its activities as a whole, operation of the resort precluded the organization from qualifying for exemption under § 501(c)(4). Operation of the resort did not “exclusively” or even “principally” promote social welfare within the meaning of § 501(c)(4). Operation of the resort had become the organization's primary activity. The Tax Court found that the organization’s commercial activities overshadowed all of its other activities.

In American Women Buyers Club, Inc. v. U.S., 338 F.2d 526 (2d Cir. 1964), the Court of Appeals concluded that the organization was not tax-exempt under § 501(c)(4) because the majority of the benefits were for its members and it did not promote social welfare.

In Contracting Plumbers Cooperative Restoration Corp. v. U.S., 488 F.2d 684 (2d Cir. 1973), the Court of Appeals concluded that a plumbers cooperative was not tax-exempt under

§ 501(c)(4) because the benefits to the members were proportional to their financial involvement, and therefore, it operated primarily for the benefit of its members, rather than for the purpose of benefiting the community as a whole.

In Geisinger Health Plan v. Commissioner, 985 F.2d 1210 (3d Cir. 1993) (remanded to Tax

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Court on a separate issue) (“Geisinger I”), the Court of Appeals considered whether an organization that provided healthcare benefits only to its subscribers could qualify for exemption under § 501(c)(3). The court focused its analysis on whether the activities of Geisinger Health Plan (“GHP”) provided a community benefit. Id. at 1219. The court concluded that providing healthcare benefits to the population limited to GHP’s paying subscribers did not result in a benefit to the community at large. Even though the Court of Appeals was considering the application of § 501(c)(3), rather than § 501(c)(4), this case also assists our analysis, because in order to qualify for exemption under § 501(c)(4), the organization in question also must show that its operations benefit the community as a whole.

In Vision Service Plan v. U.S., 2005 U.S. Dist. LEXIS 38812 (E.D. Calif.), aff'd mem., 2008 U.S. App. LEXIS 2388 (9th Cir. 2008), reh'g. denied (Apr. 9, 2008); cert. denied (Jan. 12, 2009) (hereinafter, “VSP v. USA’), Vision Service Plan (“VSP”) contracted with employers, HMOs, insurance companies and political subdivisions (collectively, “Subscribers”) to arrange for the provision of certain vision care services to Subscribers’ employees or members (collectively, “Enrollees”). VSP arranged for these services to be provided to Enrollees by contracting with independent optometrists and ophthalmologists (“Participating Providers”). VSP operated a prepaid vision care program and a self-funded program. Under the prepaid program, Subscribers contracted with VSP, agreeing to pay a fixed monthly amount to VSP in return for which Subscribers’ Enrollees are entitled to receive the contracted vision care benefits from VSP’s Participating Providers. Under the self-funded program, VSP provided administrative services, such as processing and paying claims, in exchange for an administrative fee. Most of VSP’s Enrollees were employed by its large Subscribers. VSP’s Subscribers include small and rural employers and HMOs enrolling beneficiaries under Medicare, Medicaid, and California Health Families Child Health Assistance Program. Members of the general public could not receive VSP’s services without being an employee or member of a Subscriber. Individuals who were not Enrollees were not eligible for VSP’s services and could not receive vision care benefits under VSP’s prepaid program or self-funded program. VSP’s gross revenue for 2003 was $425 million and its net income was $34 million. VSP arranged for free vision services to non-Enrollees, paid for the provision of vision services to low-income children, and incurred expenditures for community outreach and community educational programs. In relation to VSP’s revenue and accumulated surplus, these expenditures were minor.

The District Court determined that VSP did not qualify for exemption under § 501(c)(4), holding that VSP’s primary activity was not the promotion of social welfare. VSP did not offer its vision care plans to the general public; rather, its services were available only to employees or members of a subscribing employer, political subdivisions, or other groups with which VSP contracted. Further, the services it provided through its charity programs to non-Enrollees were comparatively insubstantial. The court concluded that VSP was not “primarily engaged in the promotion of social welfare,” but instead provided public benefits that were “incidental” to the “primary purpose” of “serv[ing] [its] paying members.” The court also concluded that“. . .
[D]espite VSP's charity work, the membership-based structure as well as the types of services offered, demonstrate that VSP's primary activity is not the promotion of social welfare.”

The Court of Appeals affirmed the District Court, holding that VSP is not entitled to tax-exempt status because “it is not primarily engaged in promoting the common good and general welfare of the community.” The court also found that VSP’s primary purpose, establishing a fund from

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payments by its subscribers to defray and assume their costs of vision care, “benefits VSP’s subscribers rather than the general welfare of the community.”

Exempt Status Based Upon the Integral-Part Test

Section 502 provides that, “an organization operated for the primary purpose of carrying on a trade or business for profit shall not be exempt from taxation under § 501 on the ground that all of its profits are payable to one or more organizations exempt from taxation under § 501.”

Section 1.502-1(b) provides the framework for derivative or vicarious exemption for a subsidiary organization of a tax-exempt organization that is an integral part of the parent organization. The subsidiary organization’s 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, an entity created to provide electrical power solely to its parent organization to enable the parent to conduct its exempt activity may qualify for exemption as an integral part of the parent organization. Such an organization would not qualify for exemption on this basis if it were to provide electrical services primarily to customers other than its parent. The subsidiary organization will not qualify for exemption if its primary purpose is to carry ona trade or business that would be an unrelated trade or business if engaged in by the parent.

Rev. Rul. 58-194, 1958-1 C.B. 240, holds that an organization operating a book and supply store and a cafeteria and restaurant on the campus of a state university for the convenience of the student body and faculty qualifies for exemption under § 501(c)(3). The facilities of the organization are available to everyone connected with the university, and the profits are used solely for the benefit of the students and faculty of the university. Because the organization serves almost exclusively the members of the faculty and student body and since it is performing functions for their benefit and convenience and in furtherance of the university's educational program, it is an integral part of the university.

Rev. Rul. 78-41, 1978-1 C.B. 148, describes a trust created to satisfy a specific exempt hospital's malpractice claims. The trust was created by the hospital for the sole purpose of accumulating and holding funds to be used to satisfy malpractice claims against the hospital. The hospital controlled the trust, whose trustee acted upon direction from the hospital as to the payment of claims. The trust satisfied the hospital’s obligation under state law to provide for malpractice claims and is an activity that the hospital could do directly. By serving as a repository for funds paid in by the hospital, and by making payments at the direction of the hospital to persons with malpractice claims against the hospital, the trust operated as an integral part of the hospital and was exempt under § 501(c)(3).

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, and which was controlled by the college, qualified for exemption because it bore a “close and intimate relationship” to the functioning of the college itself.

B.H.W. Anesthesia Foundation Inc. v. Commissioner, 72 T.C. 681 (1979), held that the Harvard Medical School faculty clinical practice organization created by the anesthesiology department of Harvard Medical School qualified for exemption under § 501(c)(3). A clinician could qualify for membership in the organization only so long as he or she was a clinical faculty member at

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Harvard Medical School. Control of the organization rested directly or indirectly with the chairman of the Harvard Medical School department of anesthesiology. The patients served by the organization were limited to patients of the teaching hospital. Although the organization’s revenues were used to supplement compensation paid to the members of the faculty practice, compensation was capped at an amount that the Tax Court held was reasonable and was less than the clinical faculty member would likely obtain in private practice. Accordingly, the organization comprised an integral part of Harvard Medical School and its teaching hospital, the Boston Hospital for Women. No private benefit accrued to the clinical faculty members of the organization, which would otherwise disqualify it from exempt status.

University of Massachusetts Medical School Group Practice v. Commissioner, 74 T.C. 1299 (1980), acq. 1980-2 C.B. 1, held that the organization serving as the clinical faculty practice group comprised exclusively of clinical faculty of the University of Massachusetts Medical School, was an integral part of the medical school and its teaching hospital. Members of the organization participated in the clinical teaching program at the teaching hospital and divided their time between academic pursuits (teaching and research) and clinical duties at the teaching hospital and other smaller affiliated state hospitals. The opportunity for students to observe and assist in the actual treatment of patients was considered to be a vital and necessary part of their medical education. Accordingly, the faculty members’ patient care activities at the hospital were inseparable from the faculty members’ teaching function. Members of the organization were required to hold academic appointments at the medical school and to be engaged to some degree in clinical practice. State conflict of interest laws precluded clinical faculty from personally billing patients or third party payors for their clinical services. The organization collected the fees generated by the faculty clinical services, deposited those funds into a trust fund pursuant to statute, and expended the funds for legislatively mandated purposes. Although amounts generated through the clinical practice enhanced a clinician's overall compensation, total compensation paid to the clinicians was subject to the same institutional regulations as the clinician's academic salary. The provisions regulating the allocation of clinical fees among the practicing clinicians prevented the organization from serving the private interests of the clinicians. The Tax Court found that the organization provided vital clinical training for medical students, interns, and residents, comprised an integral component of the medical school and the university hospital and, therefore, qualified for exemption.

University of Maryland Physicians, P. A. v. Commissioner, T.C. Memo. 1981-23, found that the medical practice comprised exclusively of clinical faculty of the cardiology, nephrology, pulmonary diseases, and nuclear medicine departments of the University of Maryland Medical School qualified for exemption as an integral part of the medical school and its teaching hospital. The organization’s members provided clinical services exclusively to patients at the medical school teaching hospital and were precluded from holding concurrent positions at any other medical facility or with any other practice groups.

The Tax Court found that clinical instruction is an indispensable primary component of training undergraduate and graduate students at the medical school. The clinical practice group's organizing documents limited its activities to serving the interests of the medical school and teaching hospital. The organization's clinical practice revenues were subject to the control of the medical school. Although each clinician owned shares in the stock in the organization, a shareholder could obtain no more than the nominal par value for his or her shares upon leaving the practice group. These factors precluded the faculty members from deriving an

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impermissible private benefit from the organization’s operations. Accordingly, the organization qualified for exempt status as an integral part of the University of Maryland Medical School.

Geisinger Health Plan v. Commissioner, 30 F.3d 494 (3rd Cir. 1994) (“Geisinger II”) held that Geisinger Health Plan (“GHP”) could not qualify for exemption as an integral part of a health system comprised of eight separate healthcare organizations, each of which was exempt from tax under one or more sections of the Internal Revenue Code. Geisinger II analyzed the basis on which a subordinate organization could qualify for tax-exempt status because of its relationship with one or more exempt parent organizations. The Court of Appeals rejected an analysis based upon a hypothetical merger of GHP into the parent organization. Id. at 499. Instead, Geisinger II developed the following guidelines to evaluate whether a subsidiary may be entitled to exempt status as an integral part of the exempt parent:

(1) The subsidiary does not carry on a trade or business which would be an unrelated trade or business if regularly carried on by the parent, and

(2) The relationship between the subsidiary and the parent enhances in some way the subsidiary’s own exempt character to the point that, when the “boost provided by the parent is added to the contribution made by the subsidiary itself,” the subsidiary would be entitled to exemption.

Id. at 501.

The Court of Appeals noted that the electric company described in § 1.502-1(b) served a charitable purpose solely because it provided an essential service (electric power) exclusively to a tax-exempt university. Providing electric power to paying customers is not, in itself, an exempt - purpose. However, the power company described in the Treasury Regulation possessed an exclusive relationship with the university. The power company was a wholly owned subsidiary of the university to which it supplied power. The university’s educational mission effectively became the mission of the power company. Id. at 501-2.

Geisinger II noted that GHP served a broader clientele than its parent healthcare system. In addition (citing to Geisinger I, 985 F.2d at 1219-20), the Appeals Court noted that the population served by GHP was largely limited to its paying subscribers. Accordingly, GHP was distinguishable from the types of organizations that could qualify for exemption as integral parts of their respective parent organizations. See, e.g., § 1.502-1(b); Squire v. Students Book Corp., 191 F. 2d 1018 (9th Cir. 1951); Rev. Rul. 58-194, supra.

Redlands Surgical Services v. Commissioner., 113 T.C. 47 (1999), analyzed the relationship between an exempt hospital and an ambulatory surgery center operated as a partnership between an affiliate of the exempt hospital and a for-profit entity. Among the arguments considered by the Tax Court was that the organization was an integral part of the exempt hospital. In finding that the surgical center was not an integral part of the hospital, the Tax Court found that there was no substantial overlap between the patients of the hospital and the patients of the organization. In addition, the hospital continued to maintain its own ambulatory surgical center, even after its affiliate joined with the for-profit entity to create the organization.

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IHC Health Plans, Inc. v. Commissioner, 325 F.3d 1188 (10th Cir. 2003), further develops the principle of vicarious exemption under the integral-part doctrine. In general, an entity seeking exemption from tax under § 501(a) must show that it is entitled to exemption on its own merits. However, an entity that cannot qualify for tax exemption on its own merits, may be entitled to derivative or vicarious exemption under the “integral part” doctrine if its sole activity is an integral part of the exempt affiliate’s activities. Citing the example of the power company described in § 1.501-1(b), the court stated that an essential nexus must exist between the parent and the subsidiary seeking exemption under the integral part doctrine. Important factors are whether the goods or services provided by the subsidiary to the parent are essential to the accomplishment of the parent’s exempt purposes; whether the subsidiary provides services solely to the parent (and the subsidiary does not engage in a trade or business that would be an unrelated trade or business if engaged in by the parent); and whether the parent exercises control over the subsidiary. These factors must be considered in conjunction with the exempt purpose for which the parent operates and must support a finding that the subsidiary operates for the same purpose as the parent.

Rationale

An organization described in § 501(c)(4) of the Code is operated exclusively for the promotion of social welfare if it is primarily engaged in promoting in some way the common good and general welfare of the people of the community. An organization embraced within this section is one that is operated primarily to bring about civic betterments and social improvements. An organization is not operated primarily for the promotion of social welfare if its primary activity is carrying on a business with the general public in a manner similar to organizations that are operated for profit. You do not arrange or administer healthcare services for the benefit of the community as a whole. Therefore, you do not qualify as an organization described in

§ 501(c)(4).

Social Welfare Organization

You are not primarily engaged in promoting the common good and general welfare of the people of the community. Your primary activity is arranging for health care services for subscribers for compensation. Your operations are characteristic of an organization that substantially limits the universe of potential clients. For example, 99.5 percent of your revenue in Year 3 and Year 4 will represent premiums paid by subscribers for healthcare benefits. Furthermore, 89 percent of your subscribers obtain care under employer-provided group plans, while only two percent of the subscribers purchase individual healthcare plans. Although you anticipate that, starting in Year 5, the allocation of subscribers will change as the ACA is implemented, you failed to provide a plan as to how you will accomplish a reallocation among your plan offerings. You do not demonstrate how a potential reallocation of your subscribers to include additional individual subscribers promotes social welfare, where those individual subscribers must pay a subscriber fee to obtain healthcare services from you. Furthermore, assuming we accept your speculative representations regarding subscribers through the Exchange, the number of your subscribers who are low-income and qualify for a subsidy are minor in relation to your subscriber populations as a whole. In fact, you cannot provide a direct subsidy to qualifying families and individuals (or offer policies to them at a reduced premium), because such subsidies would be contrary to State law and are also prohibited under the ACA. Instead, you will direct potential low-income individuals and families to seek premium-payment

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assistance from the S. (Your contribution to S to provide funds for healthcare premium subsidies is included among your specifically identified social welfare activities.) Accordingly, for purposes of your business of providing healthcare plans through the Exchange, no difference exists between individuals and families who qualify for subsidies and those who do not. You will receive the same premium amounts from low-income individuals and families who purchase policies through the Exchange as your subscribers who do not qualify for a subsidy.

Except for activities coordinated through G, you do not serve the general public in a manner that is more than merely incidental to the administration of your healthcare plans. Furthermore, even after we asked you, you did not provide any marketing materials that you will use to solicit subscribers; therefore, you fail to show that you will expand access to your plans or how you will accomplish that. You are not operated for the promotion of social welfare under § 501(c)(4) because you do not promote the common good and general welfare of the people of the community within the meaning of § 1.501(c)(4)-1(a) of the regulations. See VSP v. USA, 2005 U.S. Dist. LEXIS 38812 (plans primarily for employees of large employer groups); Lake Forest, 305 F.2d 814 (restricted membership, insubstantial public benefits); Contracting Plumbers Cooperative, 488 F.2d 684 (substantial and different benefits to private members); American Women Buyers, Club, 338 F.2d 526 (most benefits were for members only). Compare Rev. Rul. 54-394, supra (providing television services to members) with Rev. Rul. 62-167, supra (providing television services to all television owners in the community); and with Rev. Rul. 78- 69, supra (providing bus services to all residents in the community). See also Rev. Rul. 73-349, supra (providing groceries solely for its paying members rather than the community.); and Rev. Rul. 81-58, supra (providing direct economic benefit to its members and only incidental benefit to the community).

In addition, to qualify for tax exemption as an organization described in § 501(c)(4), your activities primarily must benefit the community rather than your paying members. See VSP v. USA, 2005 U.S. Dist. LEXIS 38812 (VSP provided public benefits that were “incidental” to the “primary purpose” of “serv[ing] [its] paying members”); Lake Forest, 305 F.2d 814 (serving a large segment of the population does not equate to “social welfare” under section 501(c)(4)); People’s Educational Camp Society, Inc., 39 T.C. 756 (operation of a resort was the organization’s primary activity rather than its social welfare activities); American Women Buyers, Club, Inc., 338 F.2d 526 (the majority of the benefits the organization provided were for its members); and Contracting Plumbers Cooperative Restoration Corp., 488 F.2d 684 (organization operated primarily for the benefits of its members, rather than for the community as a whole). You did not engage in any other substantial activities that promote social welfare. G administers your social welfare programs; however, such programs account for only one percent of your total expenditures. Thus, the benefits the community as a whole may derive from any social welfare activities are merely incidental to the health care services you arrange for your universe of enrollees with which you contract for a fee. Thus, you are not operated for the promotion of social welfare under § 501(c)(4). See VSP v. USA, 2005 U.S. Dist. LEXIS 38812 (VSP’s provision of vision services to low-income children and expenditures for community outreach and community educational programs were minor in relation to its revenue and accumulated surplus).

Integral Part of A

Generally, each organization seeking exemption under § 501(a) must qualify on its own merits.

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Geisinger II, 30 F.3d at 498; IHC Health Plans, Inc., 325 F.3d at 1202. However, where a subsidiary organization provides a necessary and essential service to its exempt parent, such that the subsidiary contributes to the accomplishment of the parent's exempt purpose, and provided that the subsidiary is not primarily engaged in a trade or business that would be an unrelated trade or business if engaged in by the parent, the subsidiary may qualify for exemption as an integral part of the parent. Section 1.502-1(b); Rev. Rul. 78-41 supra; University of Massachusetts Medical School Group Practice, 74 T.C. at 1301; University of Maryland Pysicians, P.A., T.C. Memo 1981-23; Geisinger II, 30 F.3d at 501-2; IHC Health Plans, Inc., 325 F.3d at 1202. Based upon the information that you have provided, you are not an integral part of A in any way that would qualify you for exempt status. Even though A controls your operations, you will not provide any service to A that is essential to the accomplishment of its exempt purposes

Those of your subscribers who choose to obtain primary and specialty care at A incidentally benefit the clinical, research and teaching activities of Medical School. However, your subscribers are not unique in this regard. You fail to show that you will be the only healthcare plan whose subscribers obtain care through A. You also do not show that your subscribers purchase healthcare services from you (as opposed to another healthcare plan) because they wish to contribute to the advancement of medical education or science. None of the information you have provided shows or even suggests that A would be bereft of patients if F would cease to operate or if your merger with F were to fail to occur.

A provides healthcare services to the general public. You provide healthcare services exclusively to your subscribers. Thus, there is only partial overlap of the population you serve with the population served by A. Even your subscribers who reside in County will be free to

elect not to obtain care through A. They can do this by selecting among the primary care providers and hospitals that are part of your network but are not part of A. Your subscribers who reside outside A’s County service area must generally obtain primary care from providers other than A and may obtain specialty care at A only by electing to travel to County for care. The subscribers who live outside the A service area, as well as subscribers within County who opt not to obtain care at a teaching hospital or through a faculty clinical practice, make no direct contribution to clinical education at A. (We acknowledge that the patient information for all subscribers, throughout F’s service area is provided to A, for its academic purposes; however, as discussed above, that contribution is merely incidental to services F provides to its paying subscribers. Your merger with F will not change that factor.) Because your 20-county service area will continue to be substantially larger than the A service area (which is limited to County), your operations are not essential or indispensable to medical education at A. Section 1.502- 1(b) (a power-generating facility will not qualify for exemption where it provides services to customers other than the exempt organization that operates and controls it); IHC Health Plans, Inc., 325 F.3d 1188, 1204 (a substantial portion of IHC Health Plans enrollees received physician services outside the IHC system); Redlands Surgical Services, 113 T.C. 47 (1999) (the population served by the surgical center did not overlap substantially with the population served by the exempt hospital).

You will obtain services that are essential to your operations from A. However, your purchasing services from A is not essential to the accomplishment of A’s exempt mission. Each organization that arranges for healthcare services from A to be provided to its subscribers will enter into similar service contracts. Purchasing services from Faculty Practice and Hospital for

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the benefit of your subscribers will not make you an integral part of A. Similarly, contracting with Faculty Practice to obtain medical management, disease management, technology assessment services, and wellness programs will not make you an integral part of A, nor will purchasing pharmacy management, IT management and executive management services from Hospital. A can accomplish its exempt functions without providing those services to you.

While A may appreciate the integration of F’s health records with its own, you fail to show that F’s contribution to the health records data warehouse is necessary or indispensible to the accomplishment of A’s exempt mission. A obtains patient data from multiple sources. Any benefit to A from its relationship with F is purely incidental to F’s healthcare business. Any such benefit does not differ significantly from the benefit A concurrently obtains through the other healthcare plans whose subscribers receive care at A. You have presented no information showing that this will change after you merge with, and assume the activities of, F.

Conclusion

The overwhelming majority of your activities relate to providing healthcare plans to your paying subscribers. Your specific social welfare activities represent a minor component of your overall activities. Therefore, on your own, you do not qualify as an organization that is operated exclusively for social welfare purposes within the meaning of § 501(c)(4).

Even though you are controlled by A, and have intermingled your administrative functions with affiliates of A under various service contracts, you have not shown that you will provide any necessary or indispensible service exclusively to A. Furthermore, you will continue to arrange for healthcare services to be delivered by providers and facilities outside of the A system. Thus, you fail to qualify for exemption under § 501(c)(4) as an integral part of A.

You have the right to file a protest if you believe this determination is incorrect. To protest, you must submit a statement of your views and fully explain your reasoning. You must submit the statement, signed by one of your officers, within 30 days from the date of this letter. We will consider your statement and decide if the information affects our determination.

Your protest statement should be accompanied by the following declaration:

Under penalties of perjury, I declare that I have examined this protest statement, including accompanying documents, and, to the best of my knowledge and belief, the statement contains all the relevant facts, and such facts are true, correct, and complete.

You also have a right to request a conference to discuss your protest. This request should be made when you file your protest statement. An attorney, certified public accountant, or an individual enrolled to practice before the Internal Revenue Service may represent you. If you want representation during the conference procedures, you must file a proper power of attorney, Form 2848, Power of Attorney and Declaration of Representative, if you have not already done so. For more information about representation, see Publication 947, Practice before the IRS and Power of Attorney. All forms and publications mentioned in this letter can be found at www.irs.gov, Forms and Publications.

If you do not intend to protest this determination, you do not need to take any further action. If

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we do not hear from you within 30 days, we will issue a final adverse determination letter. That letter will provide information about filing tax returns and other matters.

Please send your protest statement, Form 2848 and any supporting documents to this address:

Internal Revenue Service

1111 Constitution Ave, N.W.
Washington, DC 20224

You may also fax your statement using the fax number shown in the heading of this letter. If you fax your statement, please call the person identified in the heading of this letter to confirm that he or she received your fax.

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

Sincerely,

Karen Schiller
Acting Director, Exempt Organizations
Rulings and Agreements