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August 1999

Tax Court Ruling Threatens Non-Profit Tax-Exempt Status

In a case that could have significant impact on partnerships between nonprofit and for-profit entities, the U.S tax court has ruled that a 50-50 joint venture between non-profit Redlands Surgical Services, Inc. and for-profit Redlands-SCA Surgery Centers Inc. does not qualify for tax exempt status under Section 501 ( c) (3) of the Internal Revenue Code (Redlands Surgical Services is wholly owned by Redlands Health Systems, an exempt entity, which also operates Redlands Community Hospital through another subsidiary).

The tax court ruling affirmed an earlier ruling by the Internal Revenue Service regarding the conditions under which a charitable organization may participate in a health care partnership with a for-profit partner.

“While the tax court cited a number of factors it considered in making its decision, the common thread running through its ruling is the issue of control,” said HLB attorney Todd Swanson, who specializes in health care transactions. The court focused on the question of whether Redlands had the ability to ensure that its exempt, charitable interests were being served, versus those of its for-profit partner. Ultimately, the court concluded that, Redlands could not ensure that its goals were primary in the joint venture.

The tax court ruling may call into question the tax exempt status of other exempt entities participating in similar joint ventures. And the potential ramifications of the ruling go well beyond current arrangements. “Because of the requirements that a nonprofit entity retain control of these joint ventures, for-profit partners, who have often supplied much of the capitalization in past joint ventures, will be much more hesitant to participate,” Mr. Swanson said.

Redlands has 90 days from the July 19 ruling to appeal the tax court’s decision.

California Legislation Targets Risk-Bearing Groups

In a significant first step to regulating independent practice associations as managed care entities, the California Assembly Insurance Committee recently approved a bill that requires all risk-bearing provider organizations to annually register with and submit quarterly financial statements to the Department of Corporations (DOC).

The bill, SB 260 by Senator Jackie Speier (D-San Francisco), requires DOC to apply the financial information received to a uniform standardized rating system of risk-bearing provider organizations. The legislation also establishes a fee to be charged to licensed health plans for a new Health Care Guarantee Fund in the treasury that DOC will administer. This fund would be responsible for the payment of costs of providing health care services when a licensee is financially unable to do so. The amount of the fee would be determined by DOC.

Although SB 260 has been dramatically amended from an earlier version, in which it sought to require DOC to license all entities that assume financial risk for providing health care, the financial rating aspect of the bill could still have a significant impact on IPAs, medical groups and hospitals that accept capitation, according to HLB attorney Robert W. Lundy, who said the current vague language regarding the rating system is troublesome.

“Many IPA’s that are undercapitalized may not be able to meet the financial standards established by DOC’s rating system, and might, therefore become targets for acquisition by stronger, better capitalized companies,” Mr. Lundy said.

SB 260 is currently awaiting hearing in the Assembly Appropriations Committee along with three other related measures that could significantly impact IPAs and medical groups:

  • AB 698 (Corbett, D-San Leandro) requires DOC to create a system to ensure the financial soundness of arrangements between health plans and risk-bearing provider groups.
  • AB 78 (Gallegos, D-Los Angeles) creates a new Department of Managed Care, which would oversee health plans and disability insurers. The bill requires the new department to report to the governor by May 1, 2000, regarding the need to expand jurisdiction over medical groups and IPAs that bear significant financial risk.
  • AB 918 (Speier), would require health plans to annually update the actuarial report they are required to submit at the time of licensure and would require the report to contain the opinion of a qualified actuary regarding whether the capitation-based payment arrangements are computed appropriately.

OIG Targets Hospice Compliance Programs

Hospices that participate in the Medicare program are the latest regulatory target of the Department of Health and Human Services Office of Inspector General (OIG).

Like the compliance program guidance issued previously to home health agencies, OIG recently issued a Draft Compliance Program Guidance for hospices outlining a “voluntary” compliance program that is essentially a mandatory protocol, according to HLB attorney Gina M. Reese.

Ms. Reese currently heads a subgroup of the regulatory subcommittee of the National Hospice Organization (NHO) that is reviewing the draft guidance.

“This draft guidance establishes essentially the same framework for compliance that OIG established previously for home health agencies,” Ms. Reese said. “While the OIG states that implementation of a compliance program is voluntary, the guidelines detail certain potentially problematic areas for hospices that have been and will continue to be the focus of future regulatory efforts.”

Some of the major issues targeted by OIG in the draft regulations include:

  • Ensuring that hospice care is not provided to patients who are ineligible for coverage.
  • Ensuring that, when skilled nursing facility (SNF) patients receive hospice care, both the SNF and the hospice assume the correct amount of responsibility for the patient’s care. According to OIG, since hospices are reimbursed on a per diem basis, there is an incentive for the hospice to under-provide care.
  • High pressure marketing tactics by some hospices that emphasize the advantages of hospice coverage, such as broader medication coverage and a broader range of services, but fail to inform patients of the Medicare hospice eligibility criteria benefits they will lose by electing hospice care, including certain treatment options.
  • Hospices that recruit patients by reviewing patient records for the presence of terminal diagnoses.

The benefit of the compliance guidelines is that OIG provides hospices with a detailed list of the government’s concerns in one document, said Ms. Reese. On the other hand, it tends to criminalize certain behavior which is not, per se, illegal, she added.

Ms. Reese is also working with NHO on a regulatory proposal by the Health Care Financing Administration (HCFA) to make changes in Medicare participation requirementfor hospices. These regulations are currently in the draft stage. The committees proposed revisions will be submitted to HCFA in the next one-two months.

Comments on the draft compliance guidelines are due August 20.


Q: The Director for Business Development for our management services organization recently left our company and opened a competing business across town. Unfortunately, we did not have a written employment agreement with the employee. We need to fill the position, but we are concerned that the new employee may ultimately do the same thing. If we also make the new employee a shareholder, will we be able to establish an employment contract that includes an enforceable non-competition clause?

A: Unfortunately, there is no “bright-line” test to determine whether a court will enforce a non-competition clause. Much of the law in this area is based on court decisions that relate to specific situations.

The general rule for non-competition clauses (also known as “covenants not to compete” and “restrictive covenants”) in California, however, is rather straight forward: “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void” unless one of the specifically defined exceptions can be satisfied.

There is no exception that permits a non-competition clause to be enforced after termination of a pure employment relationship. However, there is an exception for such a clause in the context of the sale of all of ones shares in a corporation. Thus, a common approach to addressing this problem is to sell shares in the corporation to the employee upon his or her employment with the corporation, making him or her a shareholder as well as an employee. Then, as a condition to employment, require that the employ agree to sell all of his or her shares back to the corporation or another shareholder upon resignation or termination of employment.

The courts, however, have closely scrutinized such arrangements and have refused to enforce non-competition clauses unless it is clear that the shareholder is a “substantial shareholder” and the arrangement is not entered into as a mere sham device to eliminate competition. If it is apparent from the circumstances that the sale of shares to an employee is only being done in an effort to enforce a non-competition clause, it is unlikely that a court will ultimately enforce such a clause. If, however, it is apparent from the circumstances that the new employee will become a substantial shareholder in the company by, for example, owning a significant number of shares and serving as an officer or in another important capacity that contributes to the value of the company’s good will, then the clause is more likely to be enforceable upon the sale of the shares back to the company.

Q&A is a regular feature of Health Law Perspectives. If you have a question you would like addressed in a future column, please send your query to HLB attorney Robert Valencia by e-mail at, or send your question to Mr. Valencia at : Hooper, Lundy & Bookman, Inc., 1875 Century Park East, Suite 1600, Los Angeles, CA 90067.

For media assistance, please contact Maura Fisher at 202-580-7714.