Fifth Circuit affirms denial of accountable care organization’s tax exemption

The Fifth Circuit held that the Tax Court appropriately applied the substantial-nonexempt-purpose test in denying a health care organization’s assertion that it qualified as tax-exempt under Sec. 501(c)(4).

Facts: Memorial Hermann Accountable Care Organization (MHACO) was formed under Texas law in 2012 as a not-for-profit corporation. Since its formation, MHACO has been an accountable care organization in the Medicare Shared Savings Program (MSSP). Accountable care organizations in the MSSP work to manage and coordinate care for Medicare beneficiaries. If an accountable care organization satisfies cost-savings benchmarks established by the secretary of Health and Human Services, it is eligible to share in those savings. MHACO also performs similar services for patients covered by Medicare Advantage plans and employer-sponsored health plans, both of which are administered by commercial insurers. Approximately 10% of MHACO patients are part of the MSSP, 9% are covered by Medicare Advantage plans, and the remaining 81% are covered by employer-sponsored health plans. Importantly, MHACO does not provide services for individuals without some form of insurance. The proportion of annual revenues MHACO derived from its participation in the MSSP varied from year to year, from as low as 0% to as much as 87%. MHACO asserted that, over its lifetime, 65% of its revenue was derived from its participation in the MSSP.

Believing that it qualified for federal income tax exemption under Sec. 501(c)(4) as an organization operated exclusively for the promotion of social welfare, MHACO filed for recognition with the IRS. The IRS and its Independent Office of Appeals issued adverse and final adverse determination letters, respectively, concluding that MHACO was “not organized and operated for the purposes of promoting the social welfare and providing a community benefit.” As a result, MHACO timely petitioned the Tax Court. The court, however, agreed with the IRS and held that MHACO’s “non-MSSP activities primarily benefit its commercial payor and healthcare provider participants, rather than the public, and therefore constitute a substantial nonexempt purpose” (Memorial Hermann Accountable Care Org., T.C. Memo. 2023-62). In response, MHACO timely appealed to the Fifth Circuit.

Issues: Sec. 501(a) provides that organizations described in subsection (c) are generally exempt from federal income tax. Sec. 501(c)(4) provides that organizations qualify for the exemption if they are operated exclusively for the promotion of social welfare. Therefore, the Fifth Circuit considered whether the Tax Court had applied the appropriate legal standard in deciding whether MHACO qualified as a Sec. 501(c)(4) organization, whether the Tax Court’s review of the IRS’s determination was appropriate in its scope, and whether the Tax Court erred in concluding that MHACO’s non-MSSP activities disqualified it from exemption.

The court first considered the appropriate legal standard to apply in determining whether MHACO qualified as an organization that is operated exclusively for the promotion of social welfare. Following Better Business Bureau of Washington, D.C., 326 U.S. 279 (1945), the Tax Court applied the substantial-nonexempt-purpose test, which governs cases under Sec. 501(c)(3). In Better Business Bureau, the Supreme Court concluded that the presence of a single substantial nonexempt purpose “will destroy the exemption regardless of the number or importance” of truly exempt purposes. MHACO, however, argued that Better Business Bureau did not apply because MHACO is a Sec. 501(c)(4) organization and the Tax Court should have applied the primary-purpose test articulated in Regs. Sec. 1.501(c)(4)-1(a)(2)(i) instead. MHACO contended that the primary-purpose test would exempt an organization under Sec. 501(c)(4) if it is “primarily engaged in promoting in some way the common good and general welfare of the people of the community.”

The Fifth Circuit was not convinced, reasoning that both Secs. 501(c)(3) and (c)(4) use the same phrase of “operated exclusively” and that it would not make sense “to treat the same phrase differently in two neighboring paragraphs of the same statute.” Similarly, the court noted that despite not being required to “provide ‘Chevron deference’ to [the IRS’s] interpretation of [Sec.] 501(c)(4),” the IRS also argued “that the substantial nonexempt purpose and primary purpose tests are not meaningfully different, as both tests interpret the phrase ‘operated exclusively'” (see Loper Bright Enterprises v. Raimondo, 603 U.S. ٣٦٩ (٢٠٢٤)). Furthermore, the court explained that other circuits have applied the substantial-nonexempt-purpose test in the context of Sec. 501(c)(4) and that MHACO was unable to cite any case “explicitly refusing to apply the substantial nonexempt purpose standard in the [Sec.] 501(c)(4) context.” Therefore, the Fifth Circuit held that the Tax Court had applied the correct legal standard and that the substantial-nonexempt-purpose test applies to both Sec. 501(c)(3) and (c)(4) organizations.

Regarding the scope of the Tax Court’s review, MHACO argued that the Tax Court should not have upheld the IRS’s determination based on the substantial-nonexempt-purpose test because a statement in the determination letter indicated that the IRS had rejected the substantial-nonexempt-purpose test. The Fifth Circuit, however, found that, despite the IRS’s discussion of the test in the letter, the IRS’s reasoning was consistent with the Tax Court’s reasoning. Consequently, the court held that the Tax Court had not exceeded its proper scope of review of the IRS’s Sec. 501(c)(4) determination when it applied the substantial-nonexempt-purpose test in reaching its conclusion.

The court then examined the primary question of whether MHACO qualified as a Sec. 501(c)(4) organization. MHACO argued that it operated exclusively for the promotion of social welfare because “its operations are intended to increase the quality and lower the cost of health care for the greater Houston community and that any benefits accruing to insurance companies, private payors, and private providers are merely incidental.”

The Fifth Circuit rejected this argument and held that the Tax Court did not clearly err in finding that MHACO did not operate exclusively for the promotion of social welfare. Although the court noted that private businesses can be helpful to the greater community, that fact, in and of itself, is not the basis for federal income tax exemption. In particular, the court highlighted that MHACO’s services are not offered to the greater community but instead are only “provided to people with health insurance.” Additionally, despite MHACO’s contention that its private-patient—level data was used to help improve the success of the community benefits it offered, the court noted that “MHACO only uses this data to benefit its members.” As a result, the court found that MHACO’s activities do not benefit the greater community of Houston but instead represent a “members-only benefits system,” which, as previous courts have held, counsels against the conclusion that an organization is “operated exclusively for the promotion of social welfare.”

The Fifth Circuit also found that “even if MHACO’s coordinated-care services did benefit social welfare beyond its membership pool, the magnitude of MHACO’s commercial activities would still exclude it from tax exemption under [Sec.] 501(c)(4).” Given that approximately 80% of MHACO’s members are covered by employer-sponsored health plans through commercial insurers, the overwhelming majority of its operations “pertain to creating cost savings that turn into revenue for insurance companies, private providers, and private payors.” The court reasoned that these benefits do not assist the greater community of Houston and, in particular, do not address the needs of uninsured people without Medicare.

Holding: The Fifth Circuit affirmed the Tax Court decision, holding that the substantial-nonexempt-purpose test applies to Sec. 501(c)(4) organizations and that MHACO’s members-only activities, which primarily benefited commercial insurers, were not operated exclusively for the promotion of social welfare.

Memorial Hermann Accountable Care Organization, No. 23-60608 (5th Cir. 2024)

— Matthew Geiszler, Ph.D., is a lecturer in accounting in the Brooks School of Public Policy; Sadie Mecham is a master of health administration candidate in the Sloan Program in Health Administration; and John McKinley, CPA, CGMA, J.D., LL.M., is a professor of the practice in accounting and taxation in the SC Johnson College of Business, all at Cornell University. To comment on this column, contact Paul Bonner, the JofA’s tax editor.