On April 8, 2016, the Internal Revenue Service (IRS) released Private Letter Ruling (PLR) 201615022, which denied tax-exempt 501(c)(3) status to a commercial accountable care organization (ACO). This ruling marks the first time the IRS published any guidance regarding commercial ACOs. The last guidance from the IRS regarding ACOs came in 2011 and was related to ACO participation in the Medicare Shared Savings Program (MSSP). The ACO that is the subject of this PLR specifically does not participate in the MSSP. Moreover, the PLR seemingly indicates that if the ACO had been enrolled in the MSSP, its tax-exempt status would have been a non-issue.

In order to qualify for tax exempt status under 501(c)(3), an organization must be both organized and operated exclusively for an exempt purpose (e.g., religious, scientific, charitable, or educational purposes), and must demonstrate that no more than an insubstantial amount of its activities fail to support such exempt purpose. In its decision, the IRS concluded that because the commercial ACO did not exclusively promote the health of the community as a whole, but benefitted the ACO’s physicians, it could not qualify for tax-exempt status. The IRS made this determination, despite the ACO’s claims of improvement of quality of care, increasing patient satisfaction and reducing healthcare costs – all hallmarks of an effective ACO. Specifically, the IRS stated that because the ACO negotiated payor contracts on behalf of its physicians, over half of whom were not employed by the nonprofit health system that established the ACO, it obviated the reasoning for tax-exempt status. The IRS found that “a single substantial nonexempt purpose destroys the exemption, regardless of the number or importance of the exempt purposes.”

In a letter to the IRS dated May 16, 2016, the American Hospital Association (AHA) voiced its concern on behalf of its membership. In the letter, the AHA stated, “We are seriously concerned that the IRS has adopted a ruling position that means non-profit hospitals risk losing their tax exemption if they pursue a modern approach to clinically integrated health care that holds the greatest promise for improving outcomes and reducing costs.” As health systems and integrated delivery networks increasingly seek out more innovative methods to manage costs and improve quality of care, the IRS ruling seemingly makes the approach of a commercial ACO a less viable option. In fact, the IRS ruling appears to point toward possibly disastrous consequences for a tax-exempt entity that participates in a commercial ACO, including the entity’s income from such activities being subject to taxation as unrelated business income, and possibly a private business use issue related to bond proceeds, should they be used in connection with the commercial ACO. Furthermore, as the AHA alludes to, the results in this PLR raise concerns as to whether a tax-exempt organization may endanger its tax-exempt status if a substantial part of its activities involve working with an ACO.

As such, the AHA has requested the IRS, “…[P]ublish guidance affirming that hospitals may participate in ACOs without generating a tax cost or incurring a catastrophic loss of their tax-exempt status.” Although a PLR is only applicable to the specific facts at hand, and may not be relied upon as precedent, it does raise concerns as to whether an ACO that does not participate in the MSSP can qualify for tax-exempt status. Please review both the PLR and the AHA’s letter to the IRS, both of which are linked, above, and feel free to contact us with any questions you may have. We are closely monitoring this evolving issue, and will update as additional information comes available.