There’s no doubt that the healthcare industry is in a transformative time. Rising costs and continued staffing shortages are forcing health systems to strategize efficient and effective ways to manage such challenges. One popular strategy to combat these concerns is through restructuring. Mergers and acquisitions have become increasingly more common in the healthcare space throughout the last decade. Combining the power of several health systems can help hospitals expand service offerings, broaden networks and access to specialists, improve quality, and better serve patients in the areas in which they live.
Another restructuring possibility is consolidating an already existing organizational structure. Perhaps through various mergers and acquisitions over the years, a healthcare system finds itself with a handful of legal entities and needs to consolidate to better operate. One often overlooked aspect executive teams should consider when contemplating these restructures is the tax considerations. Knowing and understanding your health system’s tax status is critical in evaluating organizational restructuring as nonprofits face a host of different issues than for-profit health systems. This article will focus on restructuring from a nonprofit health system’s perspective and the various tax considerations to keep top of mind when your health system is considering restructuring.
Avoid Jeopardizing Tax-Exempt Status
First and foremost, a nonprofit health system needs to make sure any restructuring does not jeopardize its exempt status. Most nonprofit hospitals are classified as 501(c)(3) public charities. Activities that can jeopardize the exempt status of a 501(c)(3) include activities that result in private inurement, lobbying activities, political campaign activities, and having a substantial amount of unrelated business activity in comparison to the organization’s overall exempt-function activities.
Private Inurement
Private inurement occurs when an exempt organization uses its assets or income to directly or indirectly benefit an individual or organization that has a close relationship with the nonprofit. An area where the IRS often finds inurement issues is in excessive compensation to a nonprofit’s officers, directors, trustees or key employees.
When organizational restructuring happens, particularly through mergers and acquisitions, nonprofit health systems must be careful in evaluating and determining compensation for top executives so as not to trigger any private inurement issues. Best practices for helping ensure reasonable compensation include establishing a compensation committee, hiring an independent compensation consultant, utilizing written employment contracts of similarly sized health systems for reference, conducting a compensation survey or study, and the approval of either the board or compensation committee in the decision.
Lobbying Activities
Lobbying activities are allowable for 501(c)(3) organizations, but the extent to which they are permissible depends on which of two sets of rules set forth by the IRS they use when measuring their lobbying. The first set of rules, deemed the “insubstantial part” test, is the default test that applies to all 501(c)(3) organizations unless an election has been made, which we’ll cover shortly. This set of rules essentially states that an organization can conduct lobbying activities so long as the activities are not a substantial part of the organization’s overall activities. The IRS has not set a bright-line threshold and/or limits under this test, so it is quite subjective.
The other set of rules related to lobbying for 501(c)(3) organizations applies to organizations that make the 501(h) election. As opposed to the insubstantial part test, the 501(h) expenditure test sets clear limits on how much a nonprofit can spend on lobbying, based on a percentage of the organization’s total exempt purpose expenditures, capped at a maximum of $1 million. The election is made by filing IRS Form 5768. This election is attractive to nonprofits who want to engage in lobbying because it provides clarity over the ambiguous insubstantial part test as well as flexibility so that organizations can plan their lobbying activities with clearly defined parameters.
There obviously are many reasons why nonprofit health systems would want to engage in some lobbying. According to a lobbying data summary produced by OpenSecrets, the healthcare sector spent over $745 million lobbying in the United States in 2023, more than any other sector in the U.S. economy1. As important as lobbying is for the public’s health, nonprofits must be cognizant of these lobbying rules. If the IRS deems an organization to be spending a substantial amount on lobbying or if an organization exceeds the permissible lobbying expenditures under the 501(h) expenditure test, it may be subject to taxes on the excess amounts and could jeopardize its exempt status. Under either test, if a 501(c)(3) engages in lobbying for the year, it must report the activities on its annual Form 990 filing.
Political Campaign Activities
Nonprofits also must be careful in differentiating between lobbying and political activities. The IRS prohibits 501(c)(3) organizations from directly or indirectly participating or intervening in any political campaign on behalf of, or in opposition to, any candidate for public office. Doing so could result in immediate revocation of tax-exempt status and excise taxes.
Unrelated Business Activity
It is not uncommon for nonprofit health systems to engage in activities that are not directly related to their exempt purpose. If regularly carried on, these activities could give rise to unrelated business income (UBI). Nonprofits are taxed on each of their UBI activities. Besides the potential downside of having to pay tax on any UBI, these activities are not necessarily “bad” as they help provide additional revenue streams needed to help fight rising costs and continued financial pressures. These activities become an issue when they become a substantial part of the nonprofit’s overall activities. Common unrelated business activities in healthcare relate to products and/or services provided to non-patients, including but not limited to hospital pharmacy sales to non-patients and laboratory testing for non-patients.
A common strategy when nonprofit health systems are engaging in UBI activities is creating a separate for-profit subsidiary to isolate the activities. This separation helps keep the exempt organization’s tax-exempt status safe while also protecting the nonprofit from potential liability that could arise from certain business activities. The for-profit subsidiary, often classified as a C corporation, will need to file its own separate tax return and pay income tax on the net income of its activities.
One major disadvantage of a C corp is that its income is usually subject to double taxation. First, the net income gets taxed at the entity level when it files its annual Form 1120. If the corporation wanted to share its profits with its owners, it would distribute profits in the form of dividend payments to its shareholders/owners. Those shareholders/owners would then be taxed on these payments, albeit at preferential rates. However, when the sole shareholder is a tax-exempt organization, it is not subject to double taxation. IRC Section 512(b)(2) excludes all dividend payments to tax-exempt organizations from UBI.
Another consideration is to create a single-member limited liability company (SMLLC). As its name suggests, an SMLLC is wholly owned by its parent. The SMLLC is disregarded for federal income tax purposes. In the eyes of the IRS, the SMLLC is simply an extension of its parent, meaning it will take on all the same tax attributes as its parent. In the case of a nonprofit being the sole parent, the SMLLC will be exempt from federal income taxes using the same exemption as its parent and must adhere to all the same rules, regulations, and requirements as the exempt parent. Because it is disregarded for federal income tax purposes, a separate tax return is not required. Instead, all the activities of the SMLLC will be reportable on the exempt parent’s Form 990. If all or a portion of the SMLLC’s activities are considered unrelated to the exempt purpose of its parent, they will be treated as UBI and reportable on the parent’s Form 990-T.
Tax professionals often advise clients on the analysis of creating a separate for-profit subsidiary versus an SMLLC. In cases where activities may be both exempt and unrelated activities, the SMLLC route may make more sense. For example, if a nonprofit hospital starts a pharmacy serving both patients and non-patients, it might make more sense to create an SMLLC. Only the portion of pharmacy sales to non-patients would be treated as UBI and subject to taxation, whereas, if a for-profit subsidiary corporation was created, 100% of the sales to both patients and non-patients would be taxed. Both classifications still achieve the liability separation but can have differing tax implications. Another consideration to keep in mind with this analysis is whether these activities are substantial or not. As stated earlier, having substantial amounts of activities unrelated to your nonprofit’s exempt purpose could jeopardize its exempt status.
Joint Ventures
In this post-COVID-19 era, where federal stimulus funding and provider relief funding are ending, many health systems have been unable to keep pace with rising costs. They might not have the capital to start new segments and/or pursue formal mergers or acquisitions. As a result, joint ventures (JVs) have become increasingly popular in recent years. JVs are an attractive alternative for nonprofits in that they can focus on growth initiatives without the capital and operational commitments required in a full-blown merger. They also allow nonprofits to access knowledge possessed by their peers and/or expand geographically to reach more patients. Common examples of JVs with hospitals include ambulatory surgery centers, urgent care facilities, post-acute care, and physician-hospital organizations.
In simple terms, JVs are legal agreements between two or more organizations allowing them to collaborate on a common goal or project. JVs can be structured as partnerships, limited liability companies, or corporations. Nonprofits may enter into JVs with for-profits or with other nonprofits.
When nonprofits and for-profits enter into joint ventures together, it is imperative that the nonprofit assesses the activities to align with its tax-exempt purpose and mission. It is not uncommon for JVs between nonprofits and for-profits to generate UBI for the nonprofit partner. That is why it is crucial for the nonprofit to have adequate insight into all activities of the JV even if it does not have majority control.
In situations where two nonprofit healthcare organizations enter into a JV together, this consideration is usually not an issue as both organizations’ exempt purposes would typically involve promoting health and wellness.
It’s also important that the nonprofit receives fair value consideration for anything of value that it contributes to the JV and for any service arrangements that are established. All intercompany transactions should be documented closely to help ensure compliance with tax-exempt requirements to avoid potential private inurement or benefit issues and, ultimately, avoid jeopardizing the tax-exempt status of the nonprofit.
Group Tax Exemptions
Another consideration executives should keep in mind when restructuring nonprofit health systems is the possibility of a group exemption. In a time where healthcare mergers are the norm, health systems can grow massively in a short period of time. With each merger, health systems may double in size leaving a mess of legal entities underneath one umbrella. According to a December 2022 CMS dataset release, 56.1% of all Medicare-enrolled hospitals in the U.S. are part of a health system with a common owner2. Of those health systems, 58% included five or more hospitals. Most nonprofit health systems are smaller than for-profit health systems in size, but, as of the date of this dataset release, there were 27 nonprofit health systems within the U.S. that owned and operated more than 10 hospitals. Many more exist that own less than 10.
As you can imagine, nonprofit health systems, particularly larger ones, could greatly benefit under a group tax exemption. A group tax exemption is a blanket exemption the IRS grants to a “central organization” that also applies to all the central organization’s subordinates. The central organization must first apply for and be granted tax-exempt status by the IRS by filing a Form 1023 application. It then must submit a letter to the IRS requesting exemption on behalf of its subordinates. This letter must contain various information about each subordinate, including verification that the subordinates are affiliated with the central organization, are subject to the general supervision and/or control of the central organization, are eligible for tax-exempt status, are not private foundations, and other required information. Essentially, the central organization is responsible for verifying that each subordinate is eligible for tax-exempt status.
If granted exemption, subordinates do not need to separately file for tax-exempt status. Subordinate organizations are subject to the same rules, regulations, and requirements as tax-exempt organizations, which includes the requirement of annually filing the applicable Form 990 series informational return. However, subordinates can be included in a group return filed by the central organization if desired. In these situations, the activities of each subordinate organization included in the group return would be reported together.
Annually, the central organization is required to submit to the IRS’ supplemental group ruling information (SGRI) that updates any changes in operations or character of its subordinates, additions or removals of subordinates, as well as any changes to general information of each subordinate.
There are more requirements set forth by the IRS to obtain and maintain group exemptions that nonprofits must consider before pursuing that are outside the scope of this article. Nonetheless, many nonprofit health systems have been able to take advantage of this strategy. They are filing group returns for its nonprofit hospitals, thus reducing the number of Form 990s the nonprofit health system is required to file, allowing for reduced administrative costs.
However, it’s important to note that in 2020, the IRS issued proposed changes to the group exemption system in Notice 2020-36, which were intended to help alleviate some of the administrative burden placed on the IRS in monitoring the exemptions. Among the proposed changes was that a central organization would need at least five subordinate organizations to even be eligible for a group exemption. There currently is no minimum threshold. Other changes included in the proposed regulations included a matching requirement, foundation classification requirement, similar purpose requirement, and uniform governing instrument requirements. Overall, the proposed regulations, if finalized, would reduce the number of eligible subordinates. There is some relief granted in the proposed regulations that would allow pre-existing subordinates to be grandfathered in, but any new subordinates in the same group would need to adhere to the new rules.
The proposed changes have not yet been officially adopted by the IRS. Considering that the timing of when the proposed regulations were issued was right at the start of the COVID-19 pandemic, it could be a while before these regulations are final. The IRS announced with the proposed regulations that they would not be accepting new group exemption applications until final regulations are issued. Although nonprofit health systems cannot take advantage of new group exemptions currently, this possibility should be incorporated into planning strategies regarding restructuring. The group exemption option is likely not going away—it just may be more complex to meet the rules and requirements of final regulations when issued.
Other Considerations
Other tax considerations when restructuring include continued 501(r) compliance for nonprofit hospitals by streamlining policies across all hospitals, state tax implications, including unrelated business income, property, and sales, use, and transfer taxes. Each state has its own set of laws, regulations, and taxes it imposes. While nonprofit healthcare organizations are generally exempt from most taxes, there are always exceptions, so consulting with a state and local tax professional and/or legal counsel is imperative. This is especially true if a nonprofit health system is considering restructuring, which would expand its geographic footprint across multiple localities, states, and/or regions. Some states may impose a tax on the transfer of any real property. It is important to consider if your health system is considering title transfers of real estate between affiliates or as part of a merger or acquisition.
In summary, numerous perspectives must be carefully considered when health systems contemplate restructuring. Failure to thoroughly gauge the tax implications of such decisions could result in significant financial consequences. It is critical to involve tax professionals and legal counsel with focused experience during the planning stage to help mitigate potential tax risks and avoid these unintended consequences. If you need assistance or have questions, please reach out to a professional at Forvis Mazars.
- 1Ranked Sectors for 2023. opensecrets.org. Accessed August 28, 2024.
- 2“Ownership of Hospitals: An Analysis of Newly-Released Federal Data & a Method for Assessing Common Owners.” https://aspe.hhs.gov/sites/default/files/documents/a559f5e766467511608b827d4ca58cff/hospital-ownership-data-brief.pdf. August 2023.