rr-98-15.pdf

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Part I
Section 501.--Exemption From Tax on Corporations, Certain Trusts,
Etc.
26 CFR 1.501(c)(3)-1: Organizations organized and operated for
religious, charitable, scientific, testing for public safety,
literary, or educational purposes, or for the prevention of
cruelty to children or animals.
(Also §§ 170 and 509.)
Rev. Rul. 98-15, 1998-12 I.R.B.
ISSUE
Whether, under the facts described below, an organization
that operates an acute care hospital continues to qualify for
exemption from federal income tax as an organization described in
§ 501(c)(3) of the Internal Revenue Code when it forms a limited
liability company (LLC) with a for-profit corporation and then
contributes its hospital and all of its other operating assets to
the LLC, which then operates the hospital.
FACTS
Situation 1
A is a nonprofit corporation that owns and operates an acute
care hospital. A has been recognized as exempt from federal

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income tax under § 501(a) as an organization described in
§ 501(c)(3) and as other than a private foundation as defined in
§ 509(a) because it is described in § 170(b)(1)(A)(iii). B is a
for-profit corporation that owns and operates a number of
hospitals.
A concludes that it could better serve its community if it
obtained additional funding. B is interested in providing
financing for A's hospital, provided it earns a reasonable rate
of return. A and B form a limited liability company, C. A
contributes all of its operating assets, including its hospital
to C. B also contributes assets to C. In return, A and B
receive ownership interests in C proportional and equal in value
to their respective contributions.
C's Articles of Organization and Operating Agreement
("governing documents") provide that C is to be managed by a
governing board consisting of three individuals chosen by A and
two individuals chosen by B. A intends to appoint community
leaders who have experience with hospital matters, but who are
not on the hospital staff and do not otherwise engage in business
transactions with the hospital.
The governing documents further provide that they may only
be amended with the approval of both owners and that a majority
of three board members must approve certain major decisions
relating to C's operation, including decisions relating to any of
the following topics:
A. C's annual capital and operating budgets;

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B. Distributions of C’s earnings;
C. Selection of key executives;
D. Acquisition or disposition of health care facilities;
E. Contracts in excess of $x per year;
F. Changes to the types of services offered by
the hospital; and
G. Renewal or termination of management agreements.
The governing documents require that C operate any hospital
it owns in a manner that furthers charitable purposes by
promoting health for a broad cross section of its community. The
governing documents explicitly provide that the duty of the
members of the governing board to operate C in a manner that
furthers charitable purposes by promoting health for a broad
cross section of the community overrides any duty they may have
to operate C for the financial benefit of its owners.
Accordingly, in the event of a conflict between operation in
accordance with the community benefit standard and any duty to
maximize profits, the members of the governing board are to
satisfy the community benefit standard without regard to the
consequences for maximizing profitability.
The governing documents further provide that all returns of
capital and distributions of earnings made to owners of C shall
be proportional to their ownership interests in C. The terms of
the governing documents are legal, binding, and enforceable under
applicable state law.

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C enters into a management agreement with a management
company that is unrelated to A or B to provide day-to-day
management services to C. The management agreement is for a
five-year period, and the agreement is renewable for additional
five-year periods by mutual consent. The management company will
be paid a management fee for its services based on C’s gross
revenues. The terms and conditions of the management agreement,
including the fee structure and the contract term, are reasonable
and comparable to what other management firms receive for similar
services at similarly situated hospitals. C may terminate the
agreement for cause.
None of the officers, directors, or key employees of A who
were involved in making the decision to form C were promised
employment or any other inducement by C or B and their related
entities if the transaction were approved. None of A’s officers,
directors, or key employees have any interest, including any
interest through attribution determined in accordance with the
principles of § 318, in B or any of its related entities.
Pursuant to § 301.7701-3(b) of the Procedure and
Administrative Regulations, C will be treated as a partnership
for federal income tax purposes.
A intends to use any distributions it receives from C to
fund grants to support activities that promote the health of A's
community and to help the indigent obtain health care.
Substantially all of A's grantmaking will be funded by
distributions from C. A's projected grantmaking program and its

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participation as an owner of C will constitute A’s only
activities.
Situation 2
D is a nonprofit corporation that owns and operates an acute
care hospital. D has been recognized as exempt from federal
income tax under § 501(a) as an organization described in
§ 501(c)(3) and as other than a private foundation as defined in
§ 509(a) because it is described in § 170(b)(1)(A)(iii). E is a
for-profit hospital corporation that owns and operates a number
of hospitals and provides management services to several
hospitals that it does not own.
D concludes that it could better serve its community if it
obtained additional funding. E is interested in providing
financing for D's hospital, provided it earns a reasonable rate
of return. D and E form a limited liability company, F. D
contributes all of its operating assets, including its hospital
to F. E also contributes assets to F. In return, D and E
receive ownership interests proportional and equal in value to
their respective contributions.
F's Articles of Organization and Operating Agreement
("governing documents") provide that F is to be managed by a
governing board consisting of three individuals chosen by D and
three individuals chosen by E. D intends to appoint community
leaders who have experience with hospital matters, but who are
not on the hospital staff and do not otherwise engage in business
transactions with the hospital.

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The governing documents further provide that they may only
be amended with the approval of both owners and that a majority
of board members must approve certain major decisions relating to
F’s operation, including decisions relating to any of the
following topics:
A. F’s annual capital and operating budgets;
B. Distributions of F’s earnings over a required
minimum level of distributions set forth in
the Operating Agreement;
C. Unusually large contracts; and
D. Selection of key executives.
F’s governing documents provide that F’s purpose is to
construct, develop, own, manage, operate, and take other action
in connection with operating the health care facilities it owns
and engage in other health care-related activities. The
governing documents further provide that all returns of capital
and distributions of earnings made to owners of F shall be
proportional to their ownership interests in F.
F enters into a management agreement with a wholly-owned
subsidiary of E to provide day-to-day management services to F.
The management agreement is for a five-year period, and the
agreement is renewable for additional five-year periods at the
discretion of E’s subsidiary. F may terminate the agreement only
for cause. E’s subsidiary will be paid a management fee for its
services based on gross revenues. The terms and conditions of
the management agreement, including the fee structure and the

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contract term other than the renewal terms, are reasonable and
comparable to what other management firms receive for similar
services at similarly situated hospitals.
As part of the agreement to form F, D agrees to approve the
selection of two individuals to serve as F’s chief executive
officer and chief financial officer. These individuals have
previously worked for E in hospital management and have business
expertise. They will work with the management company to oversee
F’s day-to-day management. Their compensation is comparable to
what comparable executives are paid at similarly situated
hospitals.
Pursuant to § 301.7701-3(b), F will be treated as a
partnership for federal tax income purposes.
D intends to use any distributions it receives from F to
fund grants to support activities that promote the health of D's
community and to help the indigent obtain health care.
Substantially all of D's grantmaking will be funded by
distributions from F. D's projected grantmaking program and its
participation as an owner of F will constitute D's only
activities.
LAW
Section 501(c)(3) provides, in part, for the exemption from
federal income tax of corporations organized and operated
exclusively for charitable, scientific, or educational purposes,

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provided no part of the organization’s net earnings inures to the
benefit of any private shareholder or individual.
Section 1.501(c)(3)-1(c)(1) of the Income Tax Regulations
provides that an organization will be regarded as operated
exclusively for one or more exempt purposes only if it engages
primarily in activities which accomplish one or more of such
exempt purposes specified in § 501(c)(3). An organization will
not be so regarded if more than an insubstantial part of its
activities is not in furtherance of an exempt purpose. In Better
Business Bureau of Washington, D.C. v. United States, 326 U.S.
279, 283 (1945), the Court stated that "the presence of a single
. . . [non-exempt] purpose, if substantial in nature, will
destroy the exemption regardless of the number or importance of
truly . . . [exempt] purposes."
Section 1.501(c)(3)-1(d)(1)(ii) provides that an
organization is not organized or operated exclusively for exempt
purposes unless it serves a public rather than a private
interest. It further states that "to meet the requirement of
this subdivision, it is necessary for an organization to
establish that it is not organized and operated for the benefit
of private interests . . . ."
Section 1.501(c)(3)-1(d)(2) provides that the term
"charitable" is used in § 501(c)(3) in its generally accepted
legal sense. The promotion of health has long been recognized as
a charitable purpose. See Restatement (Second) of Trusts,
§§ 368, 372 (1959); 4A Austin W. Scott and William F. Fratcher,

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The Law of Trusts §§ 368, 372 (4th ed. 1989). However, not every
activity that promotes health supports tax exemption under
§ 501(c)(3). For example, selling prescription pharmaceuticals
certainly promotes health, but pharmacies cannot qualify for
recognition of exemption under § 501(c)(3) on that basis alone.
Federation Pharmacy Services, Inc. v. Commissioner, 72 T.C. 687
(1979), aff'd, 625 F.2d 804 (8th Cir. 1980) ("Federation
Pharmacy"). Furthermore, "an institution for the promotion of
health is not a charitable institution if it is privately owned
and is run for the profit of the owners." 4A Austin W. Scott and
William F. Fratcher, The Law of Trusts § 372.1 (4th ed. 1989).
See also Restatement (Second) of Trusts, § 376 (1959). This
principle applies to hospitals and other health care
organizations. As the Tax Court stated, "[w]hile the diagnosis
and cure of disease are indeed purposes that may furnish the
foundation for characterizing the activity as 'charitable,'
something more is required." Sonora Community Hospital v.
Commissioner, 46 T.C. 519, 525-526 (1966), aff'd 397 F.2d 814
(9th Cir. 1968) ("Sonora"). See also Sound Health Association v.
Commissioner, 71 T.C. 158 (1978), acq. 1981-2 C.B. 2 ("Sound
Health"); Geisinger Health Plan v. Commissioner, 985 F.2d 1210
(3rd Cir., 1993), rev'g 62 T.C.M. 1656 (1991) ("Geisinger").
In evaluating whether a nonprofit hospital qualifies as an
organization described in § 501(c)(3), Rev. Rul. 69-545, 1969-2
C.B. 117, compares two hospitals. The first hospital discussed
is controlled by a board of trustees composed of independent

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civic leaders. In addition, the hospital maintains an open
medical staff, with privileges available to all qualified
physicians; it operates a full-time emergency room open to all
regardless of ability to pay; and it otherwise admits all
patients able to pay (either themselves, or through third party
payers such as private health insurance or government programs
such as Medicare). In contrast, the second hospital is
controlled by physicians who have a substantial economic interest
in the hospital. This hospital restricts the number of
physicians admitted to the medical staff, enters into favorable
rental agreements with the individuals who control the hospital,
and limits emergency room and hospital admission substantially to
the patients of the physicians who control the hospital. Rev.
Rul. 69-545 notes that in considering whether a nonprofit
hospital is operated to serve a private benefit, the Service will
weigh all the relevant facts and circumstances in each case,
including the use and control of the hospital. The revenue
ruling concludes that the first hospital continues to qualify as
an organization described in § 501(c)(3) and the second hospital
does not because it is operated for the private benefit of the
physicians who control the hospital.
Section 509(a) provides that the term "private foundation"
means a domestic or foreign organization described in § 501(c)(3)
other than an organization described in § 509(a)(1), (2), (3), or
(4). The organizations described in § 509(a)(1) include those
described in § 170(b)(1)(A)(iii). An organization is described

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in § 170(b)(1)(A)(iii) if its principal purpose is to provide
medical or hospital care.
Section 512(c) provides that an exempt organization that is
a member of a partnership conducting an unrelated trade or
business with respect to the exempt organization must include its
share of the partnership income and deductions attributable to
that business (subject to the exceptions, additions, and
limitations in § 512(b)) in computing its unrelated business
income. See also H.R. No. 2319, 81st Cong., 2d Sess. 36, 111-112
(1950); S. Rep. No. 2375, 81st Cong., 2d Sess. 26, 109-110
(1950); § 1.512(c)-1.
In Butler v. Commissioner, 36 T.C. 1097 (1961), acq. 1962-2
C.B. 4 ("Butler"), the court examined the relationship between a
partner and a partnership for purposes of determining whether the
partner was entitled to a business bad debt deduction for a loan
he had made to the partnership that it could not repay. In
holding that the partner was entitled to the bad debt deduction,
the court noted that "[b]y reason of being a partner in a
business, petitioner was individually engaged in business."
Butler, 36 T.C. at 1106 citing Dwight A. Ward v. Commissioner, 20
T.C. 332 (1953), aff'd 224 F.2d 547 (9th Cir. 1955).
In Plumstead Theatre Society, Inc. v. Commissioner, 74 T.C.
1324 (1980), aff'd, 675 F.2d 244 (9th Cir. 1982) ("Plumstead"),
the Tax Court held that a charitable organization's participation
as a general partner in a limited partnership did not jeopardize
its exempt status. The organization co-produced a play as one of

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its charitable activities. Prior to the opening of the play, the
organization encountered financial difficulties in raising its
share of costs. In order to meet its funding obligations, the
organization formed a limited partnership in which it served as
general partner, and two individuals and a for-profit corporation
were the limited partners. One of the significant factors
supporting the Tax Court’s holding was its finding that the
limited partners had no control over the organization’s
operations.
In Broadway Theatre League of Lynchburg, Virginia, Inc. v.
U.S., 293 F.Supp. 346 (W.D.Va. 1968) ("Broadway Theatre League"),
the court held that an organization that promoted an interest in
theatrical arts did not jeopardize its exempt status when it
hired a booking organization to arrange for a series of
theatrical performances, promote the series and sell season
tickets to the series because the contract was for a reasonable
term and provided for reasonable compensation and the
organization retained ultimate authority over the activities
being managed.
In Housing Pioneers v. Commissioner, 65 T.C.M. (CCH) 2191
(1993), aff’d, 49 F.3d 1395 (9th Cir. 1995), amended 58 F.3d 401
(9th Cir. 1995) ("Housing Pioneers"), the Tax Court concluded
that an organization did not qualify as a § 501(c)(3)
organization because its activities performed as co-general
partner in for-profit limited partnerships substantially
furthered a non-exempt purpose, and serving that purpose caused

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the organization to serve private interests. The organization
entered into partnerships as a one percent co-general partner of
existing limited partnerships for the purpose of splitting the
tax benefits with the for-profit partners. Under the management
agreement, the organization’s authority as co-general partner was
narrowly circumscribed. It had no management responsibilities
and could describe only a vague charitable function of surveying
tenant needs.
In est of Hawaii v. Commissioner, 71 T.C. 1067 (1979), aff’d
in unpublished opinion 647 F.2d 170 (9th Cir. 1981) ("est of
Hawaii"), several for-profit est organizations exerted
significant indirect control over est of Hawaii, a non-profit
entity, through contractual arrangements. The Tax Court
concluded that the for-profits were able to use the non-profit as
an "instrument" to further their for-profit purposes. Neither
the fact that the for-profits lacked structural control over the
organization nor the fact that amounts paid to the for-profit
organizations under the contracts were reasonable affected the
court’s conclusion. Consequently, est of Hawaii did not qualify
as an organization described in § 501(c)(3).
In Harding Hospital, Inc. v. United States, 505 F.2d 1068
(6th Cir. 1974) ("Harding"), a non-profit hospital with an
independent board of directors executed a contract with a medical
partnership composed of seven physicians. The contract gave the
physicians control over care of the hospital's patients and the
stream of income generated by the patients while also

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guaranteeing the physicians thousands of dollars in payment for
various supervisory activities. The court held that the benefits
derived from the contract constituted sufficient private benefit
to preclude exemption.
ANALYSIS
For federal income tax purposes, the activities of a
partnership are often considered to be the activities of the
partners. See, e.g., Butler. Aggregate treatment is also
consistent with the treatment of partnerships for purpose of the
unrelated business income tax under § 512(c). See H.R. No. 2319,
81st Cong., 2d Sess. 36, 110-112 (1950); S. Rep. No. 2375, 81st
Cong., 2d Sess. 26, 109-110 (1950); § 1.512(c)-1. In light of
the aggregate principle discussed in Butler and reflected in
§ 512(c), the aggregate approach also applies for purposes of the
operational test set forth in § 1.501(c)(3)-1(c). Thus, the
activities of an LLC treated as a partnership for federal income
tax purposes are considered to be the activities of a nonprofit
organization that is an owner of the LLC when evaluating whether
the nonprofit organization is operated exclusively for exempt
purposes within the meaning of § 501(c)(3).
A § 501(c)(3) organization may form and participate in a
partnership, including an LLC treated as a partnership for
federal income tax purposes, and meet the operational test if
participation in the partnership furthers a charitable purpose,
and the partnership arrangement permits the exempt organization

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to act exclusively in furtherance of its exempt purpose and only
incidentally for the benefit of the for-profit partners. See
Plumstead and Housing Pioneers. Similarly, a § 501(c)(3)
organization may enter into a management contract with a private
party giving that party authority to conduct activities on behalf
of the organization and direct the use of the organization's
assets provided that the organization retains ultimate authority
over the assets and activities being managed and the terms and
conditions of the contract are reasonable, including reasonable
compensation and a reasonable term. See Broadway Theatre League.
However, if a private party is allowed to control or use the
non-profit organization's activities or assets for the benefit of
the private party, and the benefit is not incidental to the
accomplishment of exempt purposes, the organization will fail to
be organized and operated exclusively for exempt purposes. See
est of Hawaii; Harding; § 1.501(c)(3)-1(c)(1); and
§ 1.501(c)(3)-1(d)(1)(ii).
Situation 1
After A and B form C, and A contributes all of its operating
assets to C, A's activities will consist of the health care
services it provides through C and any grantmaking activities it
can conduct using income distributed by C. A will receive an
interest in C equal in value to the assets it contributes to C,
and A's and B's returns from C will be proportional to their
respective investments in C. The governing documents of C commit
C to providing health care services for the benefit of the

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community as a whole and to give charitable purposes priority
over maximizing profits for C’s owners. Furthermore, through A’s
appointment of members of the community familiar with the
hospital to C’s board, the board’s structure, which gives A’s
appointees voting control, and the specifically enumerated powers
of the board over changes in activities, disposition of assets,
and renewal of the management agreement, A can ensure that the
assets it owns through C and the activities it conducts through C
are used primarily to further exempt purposes. Thus, A can
ensure that the benefit to B and other private parties, like the
management company, will be incidental to the accomplishment of
charitable purposes. Additionally, the terms and conditions of
the management contract, including the terms for renewal and
termination, are reasonable. Finally, A’s grants are intended to
support education and research and give resources to help provide
health care to the indigent. All of these facts and
circumstances establish that, when A participates in forming C
and contributes all of its operating assets to C, and
C operates in accordance with its governing documents, A will be
furthering charitable purposes and continue to be operated
exclusively for exempt purposes.
Because A’s grantmaking activity will be contingent upon
receiving distributions from C, A’s principal activity will
continue to be the provision of hospital care. As long as A’s
principal activity remains the provision of hospital care, A will

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not be classified as a private foundation in accordance with
§ 509(a)(1) as an organization described in § 170(b)(1)(A)(iii).
Situation 2
When D and E form F, and D contributes its assets to F, D
will be engaged in activities that consist of the health care
services it provides through F and any grantmaking activities it
can conduct using income distributed by F. However, unlike A, D
will not be engaging primarily in activities that further an
exempt purpose. "While the diagnosis and cure of disease are
indeed purposes that may furnish the foundation for
characterizing the activity as 'charitable,' something more is
required." Sonora, 46 T.C. at 525-526. See also Federation
Pharmacy; Sound Health; and Geisinger. In the absence of a
binding obligation in F's governing documents for F to serve
charitable purposes or otherwise provide its services to the
community as a whole, F will be able to deny care to segments of
the community, such as the indigent. Because D will share
control of F with E, D will not be able to initiate programs
within F to serve new health needs within the community without
the agreement of at least one governing board member appointed by
E. As a business enterprise, E will not necessarily give
priority to the health needs of the community over the
consequences for F's profits. The primary source of information
for board members appointed by D will be the chief executives,
who have a prior relationship with E and the management company,
which is a subsidiary of E. The management company itself will

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have broad discretion over F’s activities and assets that may not
always be under the board’s supervision. For example, the
management company is permitted to enter into all but "unusually
large" contracts without board approval. The management company
may also unilaterally renew the management agreement. Based on
all these facts and circumstances, D cannot establish that the
activities it conducts through F further exempt purposes. "[I]n
order for an organization to qualify for exemption under
§ 501(c)(3) the organization must 'establish' that it is neither
organized nor operated for the 'benefit of private interests.'"
Federation Pharmacy, 625 F.2d at 809. Consequently, the benefit
to E resulting from the activities D conducts through F will not
be incidental to the furtherance of an exempt purpose. Thus, D
will fail the operational test when it forms F, contributes its
operating assets to F, and then serves as an owner of F.
HOLDING
A will continue to qualify as an organization described in
§ 501(c)(3) when it forms C and contributes all of its operating
assets to C because A has established that A will be operating
exclusively for a charitable purpose and only incidentally for
the purpose of benefiting the private interests of B.
Furthermore, A's principal activity will continue to be the
provision of hospital care when C begins operations. Thus, A
will be an organization described in § 170(b)(1)(A)(iii) and
thus, will not be classified as a private foundation in

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accordance with § 509(a)(1), as long as hospital care remains its
principal activity.
D will violate the requirements to be an organization
described in § 501(c)(3) when it forms F and contributes all of
its operating assets to F because D has failed to establish that
it will be operated exclusively for exempt purposes.
DRAFTING INFORMATION
The principal author of this revenue ruling is Judith E.
Kindell of the Exempt Organizations Division. For further
information regarding this revenue ruling contact Judith E.
Kindell on (202) 622-6494 (not a toll-free call).