On October 28, the US Court of Appeals for the Fifth Circuit held that a nonprofit corporation that coordinates health care for privately insured patients does not qualify for tax exemption under Section 501(c)(4) because it is not “operating exclusively for the promotion of social welfare.” The court upheld the US Tax Court’s ruling that the corporation’s benefits conferred upon its health care provider members constituted a substantial nonexempt purpose, applying the same standard applicable to 501(c)(3) organizations and declining to give deference to the US Department of the Treasury’s regulations implementing Section 501(c)(4).

To qualify for exemption from federal income tax as a Section 501(c)(4) organization, Section 501(c)(4) requires an organization to be “operated exclusively for the promotion of social welfare,” among other requirements. Under the Treasury regulations, an organization operates “exclusively for the promotion of social welfare if it is primarily engaged in promoting the common good and general welfare of the people of the community.” This has been interpreted to mean that a Section 501(c)(4) organization may engage in some nonexempt activity so long as its primary purpose and activities are tax exempt. This legal standard is commonly referred to as the “primary purpose” test.

For exemption as a Section 501(c)(3) organization, Section 501(c)(3) requires an organization to be “operated exclusively” for exempt purposes within the meaning of Section 501(c)(3) (i.e., religious, charitable, scientific, etc.). Section 501(c)(3) organizations, however, are subject to the “substantial nonexempt purpose” test, which is generally viewed as a more stringent standard for exemption than the “primary purpose” test. This test comes from the US Supreme Court’s opinion in Better Business Bureau of Washington DC v. United States,which upheld the denial of an organization’s tax-exempt status under Section 501(c)(3) because it was not “devoted to educational purposes exclusively … [which] plainly means the presence of a single non-educational purpose, if substantial in nature, will destroy the exemption regardless of the number or importance of truly educational purposes.” While this standard is controlling with respect to Section 501(c)(3) organizations, some circuits (now including the Fifth Circuit) have also applied the standard to Section 501(c)(4) organizations.

Memorial Hermann Accountable Care Organization v. IRS

The Memorial Hermann Accountable Care Organization (MHACO) is a Texas nonprofit corporation based in Houston that participates as an “accountable care organization” in the Medicare Shared Savings Program (MSSP) created under the Patient Protection and Affordable Care Act. As an accountable care organization, MHACO’s members consist of health care providers working together to provide coordinated patient care and cost efficiency. MHACO coordinates care for Medicare beneficiaries as well as individuals covered by employee-sponsored plans through commercial insurers. MHACO’s patient base includes approximately 10% from MSSP, 9% from Medicare Advantage Plans, and 81% from employer-sponsored health plans. MHACO does not coordinate health care services for uninsured individuals. MHACO compensates its members for successfully coordinating care and reducing health care costs.

MHACO applied for tax-exemption under Section 501(c)(4) as an organization “operated exclusively for the promotion of social welfare.” However, the Internal Revenue Service (IRS) denied MHACO tax-exempt status, finding that it was “not organized and operated for the purposes of promoting the social welfare and providing a community benefit.” The Tax Court agreed, holding that MHACO’s “non-MSSP activities primarily benefit its commercial payor and health care provider participants, rather than the public, and therefore constitute a substantial nonexempt purpose.” MHACO appealed to the Fifth Circuit, arguing in part that the Tax Court incorrectly applied the more stringent substantial nonexempt purpose test to determine whether it qualified as a Section 501(c)(4) organization.

Fifth Circuit Decision

The Fifth Circuit rejected MHACO’s argument and held that the Tax Court applied the correctlegal standardin examining whether MHACO qualified as a tax-exempt organization. It then upheld the Tax Court’s decision that MHACO’s non-MSSP activitiesdisqualified the entity from tax exemption under Section 501(c)(4). 

The Fifth Circuit analyzed whether a 501(c)(4) organization must pass the “substantial nonexempt purpose” test or the “primary purpose” test to qualify for tax exemption. Both Section 501(c)(3) and 501(c)(4) use the language “operated exclusively” for enumerated exempt purposes. The Fifth Circuit refused to interpret this phrase differently in parallel statutory provisions, relying on cases from other circuits that applied the substantial nonexempt purpose test to the Section 501(c)(4) context. Accordingly, the court held that the presence of a single nonexempt purpose, if substantial in nature, precludes tax exemption under Section 501(c)(4). The court declined to give deference to the “primary purpose” test found in the Treasury regulations, noting that courts are no longer required to provide Chevron deference to the Treasury Department’s interpretation of Section 501(c)(4).[1]

MHACO failed the test applied by the Fifth Circuit because its “non-MSSP activities” were too extensive. MHACO argued that its operations were intended to increase the quality and lower the costs of health care for the greater Houston community, and that any financial benefits that accrued to insurance companies or private payors and providers were merely incidental. The court disagreed, finding MHACO’s coordinated-care services were only offered to insured individuals and that its data collection was for the benefit of its provider members. The court cited precedent holding that organizations that provide substantial and different benefits to the public and to private members are not eligible for tax exemption under Section 501(c)(4). While MHACO argued that its membership requirement was necessary to properly allocate risk, lower costs, and ultimately achieve its charitable purposes, the court disagreed and held that MHACO’s membership requirement provided a non-incidental private benefit that constituted a substantial nonexempt purpose.

Implications

The court’s decision sets an important precedent in the Fifth Circuit for interpreting tax-exempt status not only for accountable care organizations and other organizations with membership requirements but also for any Section 501(c)(4) organization. The court’s decision may be instructive and persuasive to other courts addressing this issue. If this case is appealed to the Supreme Court, it could set an important precedent for all Section 501(c)(4) organizations. The decision could also affect politically oriented Section 501(c)(4) organizations. As recently speculated by The Wall Street Journal, this decision could be used to curb political spending by politically active Section 501(c)(4) organizations.