State Bar of Texas Health Law Section Report (Fall 1996)

IRS Grants Exempt Status to 5.01(a) Client:
First Texas Exemption Under New Rules

By letter dated June 19, 1996,⁽¹⁾ the Internal Revenue Service ("IRS") granted C.H. Wilkinson Physician Network ("Network"), a Texas nonprofit corporation that has been certified to practice medicine by the Texas State Board of Medical Examiners ("TSBME") the sole corporate member of which is SCH Health Care System ("SCH"), exemption from federal income tax as an organization described in section 5.01(c)(3) of the Internal Revenue Code (the "Code"). The favorable determination letter for Network, now a public document, is the first to be received by a Texas nonprofit corporation certified by the TSBME ("CNPC") since the IRS began applying its integrated delivery system ("IDS") analysis to physician practice groups. Significantly, the IRS review specifically took into account the current TSBME rules governing CNPCs even though Network was incorporated prior to their adoption.

Receipt by the Network of its favorable determination letter presumably signals the breakup of the IRS logjam that has thwarted CNPCs from being recognized as organizations described in section 5.01(c)(3) of the Code, despite the submission of some applications as long as four years ago. That logjam, attributed by most industry observers to the position of the IRS that physician practice organizations created as part of an IDS must have governing boards no more than 20 percent of the members of which are physicians, has been frustrating for Texas hospitals and CNPCs inasmuch as tax-exempt CNPCs offer much greater flexibility to tax-exempt hospitals that establish CNPCs. That flexibility is particularly important with respect to the capitalization or other funding of a CNPC.

Recognizing that the TSBME rules governing CNPCs are irreconcilable with its requirement that physician representation on the governing board of a physician practice component of an IDS be limited to 20 percent, the IRS concluded that the appropriate focus for determining qualification for exemption for a CNPC is the relationship between the CNPC and the tax-exempt hospital that establishes the CNPC. That relationship, inextricably linked to the TSBME rules covering certification, is the heart of the determination letter analysis. Specifically, the IRS concluded that the Network qualified as an organization described in section 5.01(c)(3) of the Code because its relationship with SCH demonstrated that the Network operated to further SCH's charitable purposes. The components of the relationship that the IRS determined to be crucial to its favorable conclusion include the following:

1. SCH's right to amend, alter or repeal Network's Articles of Incorporation and Bylaws.

2. SCH's right to approve significant actions including:

a. Network's annual operating and capital budgets and significant deviations from such budgets;

b. Network's sale, lease, mortgage or other transfer or encumbrance of real property or, above certain limits, personal property;

c. Merger, acquisition, consolidation, liquidation, or dissolution actions undertaken by Network;

d. Network's giving or seeking of grants;

e. Network's physician compensation agreements, including benefits and incentives;

f. Appointment, election or removal, and establishing or changing the number, of Network's directors, with removal being with or without cause;

g. Settlement of claims and litigation involving Network; and

h. Selection of Network's auditors.

Although the foregoing control provisions are of paramount importance to Network's ability to qualify as an organization described in section 5.01(c)(3) of the Code, the determination letter cites several other requirements that Network has, or has agreed to, fulfill. First, Network has acquired, and will acquire in the future, physician practices for no more than fair market value in transactions that comply with all applicable state and federal laws. Second, Network has a policy of nondiscrimination regarding Medicare and Medicaid beneficiaries and has committed to provide a level of medical care to indigent persons, on both an emergency and nonemergency basis, consistent with Network's available resources and taking into account Network's need to fund its ongoing activities. Third, the fee schedules established by Network are

subject to review by SCH. Fourth, Network has established a compensation committee none of the members of whom are physicians to make determinations with respect to compensation, including incentive compensation and benefits. Network has represented that compensation paid will be reasonable and will take into account compensation levels reflected in national, regional and local surveys and that incentive compensation payments will be subject to annual caps. Fifth, and finally, Network agreed to amend its Bylaws to include the model conflicts of interest policy promulgated by the IRS.

Good news for Network, the determination letter is also good news for other CNPCs established by tax-exempt hospitals since it details the considerations that must be taken into account to satisfy the IRS.

Todd Greenwalt, Health Care Section, Vinson & Elkins, Houston, Texas.

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