Last month, the American Hospital Association asked the Internal Revenue Service (IRS) to reconsider its position, articulated in a final adverse determination the agency issued in April of this year, which denied tax exemption under Section 501(c)(3) of the Internal Revenue Code for an accountable care organization (ACO) serving the commercial market. The ACO was created by a not-for-profit health system, but approximately half of the participating physicians were independent or employed by other hospitals and healthcare systems.

To the surprise of many in the healthcare community, the IRS had found that the ACO did not engage primarily in activities accomplishing one or more of Section 501(c)(3)’s exempt purposes, and that more than an insubstantial part of the ACO’s activities furthered non-exempt purposes, because a substantial part of the ACO’s activities conferred a non-incidental impermissible benefit on private interests, rather than for the benefit of public interests, as required by Section 501(c)(3).

While recognizing that the ACO was engaged in the promotion of health, which has long been established as a charitable purpose, the IRS pointed out that not every activity that promotes health furthers a charitable purpose. It noted, for example, that selling prescription pharmaceuticals promotes health, yet pharmacies are not qualified for exemption under Section 501(c)(3). The IRS also noted that one of the ACO’s substantial activities is the negotiation of payer agreements on behalf of the ACO’s independent healthcare provider participants, and that negotiating with private health insurers on behalf of unrelated healthcare providers generally is not a charitable activity, regardless of whether the agreement negotiated is a program aimed at achieving cost savings in healthcare delivery.

The IRS’s position on commercial ACOs stands in sharp—and to many, surprising—contrast to its position on ACOs that participate in the Medicare Shared Savings Program (MSSP), which the IRS views as furthering the charitable purpose of lessening the burden of government because certain provisions of the Patient Protection and Affordable Care Act (ACA) “encourage and support” ACOs and cost sharing arrangements, and because Congress established the MSSP to be conducted through ACOs in order to promote quality improvements and cost savings in health care. The IRS ruling leaves open the question of whether an ACO that does participate in the MSSP, but also participates in the commercial market, would be eligible for tax-exempt status under Section 501(c)(3).

Ruling Raises Issues Around the Viability of ACOs Serving Commercially-Insured Patients

The IRS ruling was unexpected, given the emphasis throughout the healthcare industry on shifting from traditional fee-for-service models of healthcare delivery to alternative payment models that are intended to reward providers for value rather than on volume. ACOs are on the vanguard of the volume to value shift. However, the IRS ruling raises a number of issues about the viability of the ACO model when it comes to serving commercially-insured patients, rather than just Medicare and Medicaid patients. In particular, hospitals and other tax-exempt organizations that form or participate in ACOs that serve commercial patients must now worry about whether any income they derive from those activities constitutes taxable income, and, if the income is substantial, whether such income might jeopardize their own tax-exempt status.