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Full Opinion
United States Court of Appeals
Fifth Circuit
F I L E D
November 7, 2003
UNITED STATES COURT OF APPEALS
FIFTH CIRCUIT
Charles R. Fulbruge III
Clerk
____________
No. 02-50959
Consolidated with
No. 02-51312
____________
ST. DAVIDâS HEALTH CARE SYSTEM,
Plaintiff-Appellee,
versus
UNITED STATES OF AMERICA,
Defendant-Appellant.
Appeals from the United States District Court
For the Western District of Texas
Before EMILIO M. GARZA, DENNIS, Circuit Judges, and VANCE*, District Judge.
EMILIO M. GARZA, Circuit Judge:
St. Davidâs Health Care System, Inc. (âSt. Davidâsâ) brought suit in federal court to recover
taxes that it paid under protest. St. Davidâs argued that it was a charitable hospital, and therefore tax-
exempt under 26 U.S.C. § 501(c)(3). The Government responded that St. Davidâs was not entitled
*
District Judge of the Eastern District of Louisiana, sitting by designation.
to a tax exemption because it had formed a partnership with a for-profit company and ceded control
over its operations to the for-profit entity. Both St. Davidâs and the Government filed motions for
summary judgment. The district court granted St. Davidâs motion, and ordered the Government to
refund the taxes paid by St. Davidâs for the 1996 tax year. The district court also ordered the
Government to pay $951,569.83 in attorneyâs fees and litigation costs. The Government filed the
instant appeal. We conclude that this case raises genuine issues of material fact, and that the district
court thus erred in granting St. Davidâs motion for summary judgment. We therefore vacate the
district courtâs decision, and remand for further proceedings.
I
For many years, St. Davidâs owned and operated a hospital and other health care facilities in
Austin, Texas. For most of its existence, St. Davidâs was recognized as a charitable organization
entitled to tax-exempt status under § 501(c)(3).1
In the 1990s, due to financial difficulties in the health care industry, St. Davidâs concluded that
it should consolidate with another health care organization. Ultimately, in 1996, St. Davidâs decided
to form a partnership with Columbia/HCA Healthcare Corporation (âHCAâ), a for-profit company
that operates 180 hospitals nationwide. HCA already owned several facilities in the suburbs of
Austin, and was interest ed in entering the central Austin market. A partnership with St. Davidâs
1
Non-profit organizations that are âorganized and operated exclusively for religious,
charitable, scientific, . . . literary or educational purposesâ can qualify for a tax exemption under §
501(c)(3). 26 U.S.C. § 501(c)(3). Although the statutory provision does not specifically mention
medical care, the Internal Revenue Service (âIRSâ) has long viewed the provision of health care as
a âcharitableâ purpose under § 501(c)(3). See Geisinger Health Plan v. Commissioner, 985 F.2d
1210, 1216 (3d Cir. 1993); see also Rev. Rul. 69-545, 1969-2 C.B. 117 (1969) (âThe promotion of
health . . . is one of the purposes in the general law of charity that is deemed beneficial to the
community as a whole[.]â).
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would allow HCA to expand into that urban market.
St. Davidâs contributed all of its hospital facilities to the partnership. HCA, in turn,
contributed its Austin-area facilities. The partnership hired Galen Health Care, Inc. (âGalenâ), a
subsidiary of HCA, to manage the day-to-day operations of the partnership medical facilities.
In 1998, the IRS audited St. Davidâs and concluded that, due to its partnership with HCA,
St. Davidâs no longer qualified as a charitable (and, thus, tax-exempt) hospital. The IRS ordered St.
Davidâs to pay taxes. St. Davidâs paid the requisite amount under protest, and subsequently filed the
instant action, requesting a refund.
The parties filed cross-motions for summary judgment. The district court granted the motion
filed by St. Davidâs and ordered the Government to refund the taxes paid by the hospital for the 1996
tax year. The court also decided that, because the Governmentâs position (that St. Davidâs was not
entitled to an exemption) was not substantially justified, the Government should pay attorneyâs fees
and other litigation costs in the amount of $951,569.83. See 26 U.S.C. § 7430(c)(4)(A),(B)
(indicating that the âprevailing partyâ in a tax case is entitled to attorneyâs fees and costs, unless the
Government is the non-prevailing party and establishes that its position was âsubstantially justifiedâ).
The Government filed this appeal.
II
We review the district courtâs ruling on a motion for summary judgment de novo, applying
the same legal standard as the district court. Wyatt v. Hunt Plywood Co., 297 F.3d 405, 408 (5th
Cir. 2002). Summary judgment should be granted only when there is âno genuine issue as to any
material fact[.]â FED. R. CIV. P. 56(c); Wyatt, 297 F.3d at 408-09. An issue of fact is material only
âif its resolution could affect the outcome of the action.â Wyatt, 297 F.3d at 409.
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In determining whether there is a dispute as to any material fact, we consider all of the
evidence in the record, but we do not make credibility determinations or weigh the evidence. Reeves
v. Sanderson Plumbing Prods., Inc., 530 U.S. 133, 150 (2000). Instead, we âdraw all reasonable
inferences in favor of the nonmoving party[.]â Id.; Wyatt, 297 F.3d at 409. If we determine, after
accepting the facts as presented by the nonmoving party, that âthe moving party is entitled to a
judgment as a matter of law,â we affirm the grant of summary judgment. FED. R. CIV. P. 56(c).
The Government claims that the district court erred in concluding that St. Davidâs was entitled
to § 501(c)(3) tax-exempt status. The burden was on St. Davidâs to prove that it qualified for a tax
exemption. See Nationalist Movement v. Commissioner, 37 F.3d 216, 219 (5th Cir. 1994); Senior
Citizens Stores, Inc. v. United States, 602 F.2d 711, 713 (5th Cir. 1979) (âIt is the burden of the
party claiming the exemption . . . to prove entitlement to it.â).
In order to qualify for tax-exempt status, St. Davidâs was required to show that it was
âorganized and operated exclusivelyâ for a charitable purpose. 26 C.F.R. § 1.501(c)(3)-1(a). The
âorganizational testâ required St. Davidâs to demonstrate that its founding documents: (1) limit its
purpose to âone or more exempt purposesâ; and (2) do not expressly empower St. Davidâs to engage
more than âan insubstantial part of its activitiesâ in conduct that fails to further its charitable goals.
Id. § 1.501(c)(3)-1(b). The parties agree that St. Davidâs articles of incorporation satisfy the
organizational test.
To pass the âoperational test,â St. Davidâs was required to show: (1) that it âengage[s]
primarily in activities which accomplishâ its exempt purpose; (2) that its net earnings do not âinure
to the benefit of private shareholders or individualsâ; (3) that it does ânot expend a substantial part
of its resources attempting to influence legislation or political campaignsâ; and (4) that it âserve[s]
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a valid purpose and confer[s] a public benefit.â Nationalist Movement, 37 F.3d at 219-20. The
parties appear to agree that, because St. Davidâs contributed all of its medical facilities to the
partnership, we must look to the activities of the partnership to determine if St. Davidâs satisfies the
operational test.
The Government argues that St. Davidâs cannot demonstrate the first element of the
operational test.2 The Government asserts that, because of its partnership with HCA, St. Davidâs
cannot show that it engages âprimarilyâ in activities that accomplish its charitable purpose. The
Government does not contend that a non-profit organization should automatically lose its tax-exempt
status when it forms a partnership with a for-profit entity. Instead, the Government argues that a
non-profit organization must sacrifice its tax exemption if it cedes control over the partnership to the
for-profit entity. The Government asserts that, when a non-profit cedes control, it can no longer
ensure that its activities via the partnership primarily further its charitable purpose. In this case, the
Government contends that St. Davidâs forfeited its exemption because it ceded control over its
operations to HCA.
St. Davidâs responds in part that the central issue in determining its tax-exempt status is not
which entity controls the partnership. Instead, St. Davidâs appears to assert, the pivotal question is
one of function: whether the partnership engages in activities that further its exempt purpose. St.
Davidâs argues that it passes the âoperational testâ because its activities via the partnership further
its charitable purpose of providing health care to all persons.
St. Davidâs relies in part icular on a revenue ruling issued by the IRS, which provides
guidelines for hospitals seeking a § 501(c)(3) exemption. Revenue Ruling 69-545 sets forth what has
2
The parties agree that St. Davidâs satisfies the other three elements of the test.
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come to be known as the âcommunity benefit standard.â See IHC Health Plans, Inc. v.
Commissioner, 325 F.3d 1188, 1197 (10th Cir. 2003); see also Rev. Rul. 83-157, 1983-2 C.B. 94
(1983) (noting that hospitals can be tax-exempt if various factors demonstrate that the âhospitals
operate exclusively to the benefit of the communityâ). The IRS generally accords tax-exempt status
to independent non-profit hospitals that satisfy this standard.
Under the âcommunity benefit standard,â a non-profit hospital can qualify for a tax exemption
if it: (1) provides an emergency room open to all persons, regardless of their ability to pay; (2) is
willing to hire any qualified physician; (3) is run by an independent board of trustees composed of
representatives of the community (âcommunity boardâ); and (4) uses all excess revenues to improve
facilities, provide educational services, and/or conduct medical research. See Rev. Rul. 69-545, 1969-
2 C.B. 117 (1969) (outlining the community benefit standard); see also IHC Health Plans, 325 F.3d
at 1197 n.16 (noting several relevant factors for determining whether a hospital confers a significant
community benefit, including the provision of free or below-cost care; the treatment of individuals
eligible for Medicare or Medicaid; the use of extra funds for research and educational programs; and
the composition of the board o f trustees). A hospital need not demonstrate all of these factors in
order to qualify for § 501(c)(3) tax-exempt status. See Geisinger, 985 F.2d at 1219; Rev. Rul. 69-
545, 1969-2 C.B. 117 (1969) (stating that â[t]he absence of particular factorsâ will not necessarily
prevent a hospital from obtaining an exemption); see also Rev. Rul. 83-157, 1983-2 C.B. 94 (1983)
(noting that, under certain circumstances, a hospital can satisfy the community benefit standard even
if it does not pro vide free emergency room care). Instead, the hospital must show, based on the
âtotality of the circumstances,â that it is entitled to a tax exemption. Geisinger, 985 F.2d at 1219.
St. Davidâs contends that its activities via the partnership more than satisfy the community
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benefit standard. St. Davidâs notes that the partnership hospitals perform a number of charitable
functions in the Austin community. According to St. Davidâs, the partnership not only provides free
emergency room care, but also has opened the rest of its facilities to all persons, regardless of their
ability to pay.3 In addition, St. Davidâs asserts, the partnership hospitals maintain open medical staffs.
Finally, St. Davidâs states that it uses the profits that it receives from the partnership revenues to fund
research grants and other health-related initiatives.4
We have no doubt that St. Davidâs via the partnership provides important medical services
3
The Government suggests that there is a factual dispute regarding whether the partnership
provides free care, because the partnership hospitals seek to collect payment from all patients.
However, as the Government concedes in its original brief, âcollection efforts do not definitively
indicate that . . . care [is] not charitable.â See also Maynard Hosp., Inc. v. Commissioner, 52 T.C.
1006, 1026 (1969) (indicating that âcharitable servicesâ may include collection attempts, as long as
â[p]atients who were found unable to pay their bills often had them reduced or entirely canceledâ).
The arguments made by the Government regarding St. Davidâs collection efforts fail to create a
genuine issue of fact as to whether the partnership facilities dispense charity care.
4
The Government contends that the partnership hospitals do not satisfy the community
benefit standard, because the partnership lacks a community board. The Government notes that half
of the members of the partnershipâs Board of Governors are appointed by HCA, and that two of the
members appointed by St. Davidâs are physicians at partnership hospitals. The Government contends
that these individuals have a financial interest in the partnership hospitals, and therefore cannot be
deemed âindependentâ representatives of the community who are likely to give a high priority to
charitable concerns. Cf. Rev. Rul. 69-545, 1969-2 C.B. 117 (1969) (indicating that a hospital is
more likely to perform charitable work that benefits the community if its board of directors is
composed of independent community members, and not composed of individuals who have a financial
interest in the hospital).
The Government may be correct in asserting that the partnership does not have a community
board. However, this fact does not suggest that the partnership hospitals fail to meet the community
benefit standard. As we have just explained, a hospital need not demonstrate every factor set forth
in Revenue Ruling 69-545 in order to qualify for a tax exemption. The partnership hospitals can
therefore satisfy the community benefit standard, whether or not they are run by an independent
community board.
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to the Austin community.5 Indeed, if the issue in this case were whether the partnership performed
any charitable funct ions, we would be inclined to affirm the district courtâs grant of summary
judgment in favor of St. Davidâs.
However, we cannot agree with St. Davidâs suggestion that the central issue in this case is
whether the partnership provides some (or even an extensive amount of) charitable services. It is
important to keep in mind that § 501(c)(3) confers tax-exempt status only on those organizations that
operate exclusively in furtherance of exempt purposes. 26 C.F.R. § 1.501(c)(3)-1(a). As a result,
in determining whether an organization satisfies the operational test, we do not simply consider
whether the organizationâs activities further its charitable purposes. We must also ensure that those
activities do not substantially further other (non-charitable) purposes. If more than an âinsubstantialâ
amount of the partnershipâs activities further non-charitable interests, then St. Davidâs can no longer
be deemed to operate exclusively for charitable purposes. See Nationalist Movement, 37 F.3d at 220
(ââAn organization will not be . . . regarded [as operated exclusively for an exempt purpose] if more
than an insubstantial part of its activities is not in furtherance of an exempt purpose.ââ) (quoting 26
C.F.R. § 1.501(c)(3)-1(c)(1)).6
Therefore, even if St. Davidâs performs important charitable functions, St. Davidâs cannot
qualify for tax-exempt status under § 501(c)(3) if its activities via the partnership substantially further
5
The amicus brief filed by the City of Austin confirms that St. Davidâs performs important
charitable work in the Austin area.
6
As St. Davidâs points out, the requirement that an organization operate âexclusivelyâ for
exempt purposes is not as absolute as the term âexclusiveâ might make it appear. An organization
can be deemed to operate exclusively for exempt purposes if it engages âprimarilyâ in activities that
further its charitable purposes. See Nationalist Movement, 37 F.3d at 219. Nonetheless, an
organization cannot be deemed to operate exclusively or primarily for charitable purposes when a
substantial portion of the organizationâs activities further non-charitable purposes.
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the private, profit-seeking interests of HCA. See id. at 220 (ââ[T]he 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.ââ) (quoting Better Business Bureau of Washington, D.C. v.
United States, 326 U.S. 279, 283 (1945)); cf. Est of Hawaii v. Commissioner, 71 T.C. 1067, 1078-79
(1979) (âThe operational test focuses on the purpose rather than the nature of an organizationâs
activities.â) (citation omitted) (emphasis added).
In order to ascertain whether an organization furthers non-charitable interests, we can
examine the structure and management of the organization. See Church of Ethereal Joy v.
Commissioner, 83 T.C. 20, 22-23 (1984). In other words, we look to which individuals or entities
control the organization. See id. at 23; see also Lowry Hosp. Assân v. Commissioner, 66 T.C. 850,
859-60 (1976) (concluding that a hospital could not be deemed to operate exclusively for charitable
purposes, partly because of the âcontrol and dominanceâ exercised by a single physician over the
hospitalâs affairs). If private individuals or for-profit entities have either formal or effective control,
we presume that the organization furthers the profit-seeking motivations of those private individuals
or entities. That is true, even when the organization is a partnership between a non-profit and a for-
profit entity.7 See Redlands Surgical Servs. v. Commissioner, 113 T.C. 47, 75 (1999) (âAn
organizationâs property may be impermissibly devoted to a private use where private interests have
control, directly or indirectly, over its assets, and thereby secure nonincidental private benefits.â).8
7
For purposes of simplicity, we use the term âpartnershipâ to refer to a number of similar
combinations between non-profit organizations and for-profit entities, including limited partnerships
and limited liability companies.
8
In Redlands, the tax court was presented with a situation that, in many ways, resembles the
present case. In Redlands, a non-profit organization formed a partnership with a for-profit entity to
operate a surgical center. 113 T.C. at 48, 64. The tax court stated that the non-profit would not
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When the non-profit organization cedes control over the partnership to the for-profit entity, we
assume that the partnershipâs activities substantially further the for-profitâs interests. As a result, we
conclude that the non-profitâs activities via the partnership are not exclusively or primarily in
furtherance of its charitable purposes. Thus, the non-profit is not entitled to a tax exemption. See
Rev. Rul. 98-15, 1998-1 C.B. 718 (1998) (â[I]f a private party is allowed to control or use the non-
profit organizat ionâs 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.â); see also Est of Hawaii, 71 T.C. at 1080 (concluding
that a non-pro fit could not qualify for tax-exempt status, because it was effectively, although not
formally, controlled by for-profit interests); cf. Church of Ethereal Joy, 83 T.C. at 23 (âAlthough
control by . . . a small group may not necessarily disqualify [an organization] for exemption, it
provides an o bvious opportunity for abuse of the claimed tax-exempt status.â) (internal quotation
marks omitted).
automatically lose its tax-exempt status because it had entered a partnership with a for-profit entity.
Id. at 74-75. However, the court indicated, the non-profit organization might not qualify for a tax
exemption if it lacked control over the partnership. See id. at 75. The non-profit organization in
Redlands argued that the central issue was not one of control. Id. at 77. Instead, the non-profit
contended, the central question should be whether the partnership in fact performed charitable work.
Id. The tax court rejected this position, and appeared to conclude that the central issue was indeed
one of control. See id. at 78 (âTo the extent that [the non-profit organization] cedes control over its
sole activity to for-profit parties having an independent economic interest in the same activity and
having no obligation to put charitable purposes ahead of profit-making objectives, [the non-profit]
cannot be assured that the partnerships will in fact be operated in furtherance of charitable purposes.
In such a circumstance, we are led to the conclusion that [the non-profit] is not operated exclusively
for charitable purposes.â). The Ninth Circuit, in a short per curiam opinion, affirmed. Redlands
Surgical Servs. v. Commissioner, 242 F.3d 904, 904-05 (9th Cir. 2001). Notably, the court of
appeals stated that âwe adopt the tax courtâs holding that [the non-profit organization] has ceded
effective control over the operations of the partnerships and the surgery center to private parties,
conferring impermissible private benefit.â Id. at 904 (internal quotation marks omitted) (emphasis
added).
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Conversely, if the non-profit organization enters into a partnership agreement with a for-profit
entity, and retains control, we presume that the non-profitâs activities via the partnership primarily
further exempt purposes. Therefore, we can conclude that the non-profit organization should retain
its tax-exempt status. See Plumstead Theatre Socây, Inc. v. Commissioner, 74 T.C. 1324, 1334
(1980) (concluding that a non-profit theater organization could retain its tax-exempt status, even
after forming a limited partnership with a for-profit entity, in part because â[t]he limited partners have
no control over the way [the non-profit organization] operates or manages its affairsâ); see also
Broadway Theatre League of Lynchburg, Va., Inc. v. United States, 293 F. Supp. 346, 354 (W.D.
Va. 1968) (concluding that a non-profit theater group could maintain its tax-exempt status, even after
entering a contract with a for-profit booking agent, because the contract did not give the agent
control over the operations of the non-profit).
The present case illustrates why, when a non-profit organization forms a partnership with a
for-profit entity, courts should be concerned about the relinquishment of control. St. Davidâs, by its
own account, entered the partnership with HCA out of financial necessity (to obtai n the revenues
needed for it to stay afloat). HCA, by contrast, ent ered the partnership for reasons of financial
convenience (to enter a new market). The starkly different financial positions of these two parties
at the beginning of their partnership negotiations undoubtedly affected their relative bargaining
strength. Because St. Davidâs âneededâ this partnership more than HCA, St. Davidâs may have been
willing to acquiesce to many (if not most) of HCAâs demands for the final Partnership Agreement.
In the process, of course, St. Davidâs may not have been able to give a high priority to its charitable
objectives. As a result, St. Davidâs may not have been able to ensure that its partnership with HCA
would continually provide a âpublic benefitâ as opposed to a private benefit for HCA. Cf. IHC
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Health Plans, 325 F.3d at 1195 (noting that tax exemptions under § 501(c)(3) constitute a kind of
âquid pro quoâ and ââare justified on the basis that the exempt entity confers a public benefitâa
benefit which the society or the community may not itself choose or be able to provide, or which
supplements and advances the work of public institutions already supported by tax revenuesââ)
(quoting Bob Jones Univ. v. United States, 461 U.S. 574, 591 (1983)) (emphasis in original).
These precedents and policy concerns indicate that, when a non-profit organization forms a
partnership with a for-profit entity, the non-profit should lose its tax-exempt status if it cedes control
to the for-profit entity. See Redlands, 242 F.3d at 904 (holding that a non-profit organization is no
longer entitled to tax-exempt status when it âhas ceded effective control . . . to private partiesâ)
(internal quotation marks omitted). Therefore, in our review of the district courtâs summary
judgment ruling, we examine whether St. Davidâs has shown that there is no genuine issue of material
fact regarding whether St. Davidâs ceded control to HCA.
A recent IRS revenue ruling provides a starting point for our analysis. In Revenue Ruling
98-15, the IRS indicated how a non-profit organization that forms a partnership with a for-profit
entity can establish that it has retained control over the partnershipâs activities. See Rev. Rul. 98-15,
1998-1 C.B. 718 (1998). The revenue ruling states that a non-profit can demonstrate control by
showing some or all of the following: (1) that the founding documents of the partnership expressly
state that it has a charitable purpose and that the charitable purpose will take priority over all other
concerns; (2) that the partnership agreement gives the non-profit organization a majority vote in the
partnershipâs board of directors; and (3) that the partnership is managed by an independent company
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(an organization that is not affiliated with the for-profit entity). See id.9
The partnership documents in the present case, examined in light of the above factors, leave
us uncertain as to whether St. Davidâs has ceded control to HCA. St. Davidâs did manage to secure
some pro tections for its charitable mission. First of all, Section 3.2 of the Partnership Agreement
expressly states that the manager of the partnership âshallâ operate the partnership facilities in a
manner that complies with the community benefit standard.10 This provision appears to comport with
9
We generally accord significant weight to the determinations of the IRS in its revenue
rulings. See Estate of McLendon v. Commissioner, 135 F.3d 1017, 1023 n.10 (5th Cir. 1998) (âIn
this circuit, revenue rulings are generally given weight as expressing the studied view of the agency
whose duty it is to carry out the statute.â) (internal quotation marks omitted); but see also id. at 1024
(noting that revenue rulings are âclearly less binding on the courts than treasury regulations or Code
provisionsâ).
St. Davidâs contends that the most relevant IRS guideline is Revenue Ruling 69-545. As
discussed above, that ruling lists the factors that govern whether a hospital (acting independently) can
be deemed a charitable organization. See Rev. Rul. 69-545, 1969-2 C.B. 117 (1969). Revenue
Ruling 69-545, however, is not directly on point. The ruling does not address the situation presented
by this case: how a charitable hospital can retain its tax-exempt status when it forms a partnership
with a for-profit entity. Revenue Ruling 98-15, which expressly deals with that issue, serves as a
better guide in the instant case.
10
Section 3.2 of the Partnership Agreement states:
In furtherance of the purposes of the Partnership described in Section
3.1, the Manager shall cause the Facilities to conduct the business and
operations of the Partnership in such a manner as to satisfy the
community benefits standard generally required of hospitals under
Section 501(c)(3) of the Code of (i) accepting Medicare and Medicaid
patients, (ii) accepting all patients in an emergency condition in their
emergency rooms without regard to the ability of such emergency
patients to pay, (iii) maintaining open medical staffs, (iv) providing
public health programs of educational benefit to the community, and
(v) generally promoting the health, wellness and welfare of the
community by providing quality health care at a reasonable cost. The
Partnership intends to operate its business in such a manner so as not
to jeopardize the status of [St. Davidâs] or the [St. Davidâs] Affiliates,
to the extent applicable, as organizations described in Section
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the first factor in Revenue Ruling 98-15, which indicates that the partnershipâs founding documents
should contain a statement of the partnershipâs charitable purpose. See Rev. Rul. 98-15, 1998-1 C.B.
718 (1998) (indicating that â[t]he governing documentsâ of the partnership should âcommit [the
partnership] to providing health care services for the benefit of the community as a whole and to give
charitable purposes priority over maximizing profitsâ); compare Redlands, 113 T.C. at 78-79 (noting,
as a factor suggesting that the non-profit organization lacked control, that the partnership documents
did not expressly state that the partnership had a charitable mission).11 St. Davidâs asserts that if
Galen, the manager of the partnership facilities, fails to adhere to this requirement, St. Davidâs can
sue in Texas state court for specific performance of the Partnership Agreement.
The Management Services Agreement between Galen and the Partnership further provides
that, if Galen takes any action with a âmaterial probability of adversely affectingâ St. Davidâs tax-
501(c)(3) of the Code.
11
The Government contends that Section 3.2 of the Partnership Agreement does not meet the
standard established by Revenue Ruling 98-15. The Government argues that it is not sufficient for
a partnership agreement to state that a manager âshallâ abide by the community benefit standard; the
agreement must also expressly require the manager to place charitable concerns above other goals.
We are not persuaded by the Governmentâs narrow interpretation of Revenue Ruling 98-15.
The term âshallâ clearly indicates that the manager of this partnership is required to abide by the
community benefit standard. See Valdez v. Cockrell, 274 F.3d 941, 950 (5th Cir. 2001) (âThe word
âshallâ is mandatory in meaning.â); In re DP Partners Ltd. Pâship, 106 F.3d 667, 670-71 (5th Cir.
1997) (âUse of the word âshallâ connotes a mandatory intent.â). The mandatory nature of Section
3.2 is further evidenced by the specificity of the provision: it carefully lays out the manner in which
the manager âshallâ adhere to the community benefit standard. See supra note 10.
As our discussion below indicates, Section 3.2 cannot, standing alone, ensure that St. Davidâs
has an adequate amount of control over partnership operations. Other provisions of the partnership
documents must provide St. Davidâs with an effective means of enforcing the managerâs obligation
to abide by the community benefit standard. See infra. Nevertheless, as a purely textual matter, the
purpose statement in Section 3.2 appears to comply with the first factor listed in Revenue Ruling 98-
15.
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exempt status, that action will be considered an â[e]vent of [d]efault.â Management Services
Agreement, section 7(d). The Management Services Agreement authorizes St. Davidâs to unilaterally
terminate the contract with Galen if it commits such a âdefault.â See Management Services
Agreement, section 7 (âIf any Event of Default shall occur and be continuing, the non-defaulting party
may terminate this Agreement . . . . Any action to be taken by the Partnership under this paragraph
may be taken by the [St. Davidâs] representatives on the Governing Board[.]â).
In addition, St. Davidâs can exercise a certain degree of control over the partnership via its
membership on the partnershipâs Board of Governors. St. Davidâs and HCA each appoint half of the
Board. No measure can pass the Board without the support of a majority of the representatives of
both St. Davidâs and HCA. See Partnership Agreement, section 1.8 (noting that Board approval
âmeans approval of not less than a majority of a quorum of [HCA] Governors and not less than a
majority of a quorum of [St. Davidâs] Governorsâ). Thus, through its voting power, St. Davidâs can
effectively veto any proposed action of the Board of Governors.
St. Davidâs also contends that the Partnership Agreement gives it authority over the
partnershipâs Chief Executive Officer (âCEOâ). The agreement permitted St. Davidâs to appoint the
initial CEO, subject to the approval of the HCA members of the Board of Governors. See Partnership
Agreement, section 8.2. The agreement further provides that either HCA or St. Davidâs can
unilaterally remove the CEO. See id. St. Davidâs suggests that this termination power enables it to
ensure that the CEO will promote charitable objectives.
Finally, St. Davidâs argues that its power to dissolve the partnership provides it with a
significant amount of control over partnership operations. The Partnership Agreement states that,
if St. Davidâs receives legal advice (from an attorney that has been deemed acceptable by both HCA
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and St. Davidâs) that its participation in the partnership will hinder its tax-exempt status, St. Davidâs
can request dissolution. See Partnership Agreement, section 15.1(f). St. Davidâs asserts that it can
use the threat of dissolution to force the partnership to give priority to charitable concerns.
According to St. Davidâs, the above protections in the partnership documents (the purpose
statement in the Partnership Agreement; St. Davidâs power to terminate the Management Services
Agreement and the CEO; its ability to block proposed action of the Board of Governors; and its
power of dissolution) provide it with a large measure of control over partnership operations.
However, as the Government argues, there are reasons to doubt that the partnership
documents provide St. Davidâs with sufficient control. First of all, St. Davidâs authority within the
Board of Governors is limited. St. Davidâs does not control a majority of the Board. See Rev. Rul.
98-15, 1998-1 C.B. 718 (1998) (indicating that a non-profit can retain control over a partnership with
a for-profit if it selects a majority of the partnershipâs board of directors, but will have difficulty
controlling the partnership if it has only an equal share of the board). As a result, although St. Davidâs
can veto board actions, it does not appear that it can initiate action without the support of HCA.
Thus, at best, St. Davidâs can prevent the partnership from taking action that might undermine its
charitable goals; St. Davidâs cannot necessarily ensure that the partnership will take new action that
furthers its charitable purposes. See Redlands, 113 T.C. at 79-80 (finding that the non-profit did not
have sufficient control in part because the non-profit could only veto partnership action; the non-
profit could not initiate action without the consent of the for-profit entity).12
12
St. Davidâs appears to contend that its authority to appoint the chairman of the Board of
Governors, see Partnership Agreement, section 8.4(b)(i), gives it a significant amount of control over
the Board. It is not clear, however, how this appointment power provides St. Davidâs with any real
authority. The Partnership Agreement does not appear to permit the chairman to make decisions or
initiate action without the consent of the rest of the Board. See Partnership Agreement, section
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Second, Galen, which manages the operations of the partnership on a day-to-day basis, is a
for-profit subsidiary of HCA. As a result, it is not apparent that Galen would be inclined to serve
charitable interests. It seems more likely that Galen would prioritize the (presumably non-charitable)
interests of its parent organization, HCA. See Rev. Rul. 98-15, 1998-1 C.B. 718 (1998) (indicating
that a charitable hospital is unlikely to be in control of a partnership with a for-profit entity when the
partnership manager is a subsidiary of the for-profit entity); see also Redlands, 113 T.C. at 83-84
(â[T]his long-term management contract with an affiliate of [the for-profit entity] is a salient indicator
of [the non-profitâs] surrender of effective control over the [partnershipâs] operationsâ).13
8.4(c) (â[N]o member of the Governing Board, acting alone, shall have the authority to act on behalf
of the Governing Board.â). Thus, it does not seem that the chairman could initiate any action without
the support of a majority of the HCA representatives on the Board.
13
Our concerns about Galenâs affiliation with HCA are magnified by the fact that the
partnershipâs contract with Galen appoints the manager for an extraordinarily long term. The
Management Services Agreement states that Galen will remain the manager until 2050, as long as an
HCA affiliate continues to be a general partner of the partnership. See Management Services
Agreement, section 6. Such âjob securityâ could make Galen less responsive to any allegations by
St. Davidâs that Galen was not managing the partnership in accordance with the community benefit
standard. See Redlands, 113 T.C. at 82-83 (finding problematic the fact that the partnership was
âlocked intoâ a management contract with an affiliate of the for-profit partner, when the contract
provided for a 15-year term and the possibility of renewing that term for two additional five-year
periods).
In addition, part of Galenâs fee is computed as a percentage (1%) of the partnershipâs net
revenues. See Management Services Agreement, section 5(a). Such a contingency could give Galen
an incentive to maximize revenues, and to neglect charitable goals. This fact, standing alone, does
not necessarily preclude tax-exempt status for the non-profit partner. See Rev. Rul. 98-15, 1998-1
C.B. 718 (1998) (noting that a partnership paid its manager a fee based on the partnershipâs gross
revenues, and nonetheless concluding that the non-profit member of the partnership was entitled to
tax-exempt status). However, this fact, particularly when considered in light of Galenâs relationship
with HCA, does suggest that Galen will not be inclined to prioritize charitable goals. See Redlands,
113 T.C. at 80 (citing the fact that the manager âderive[d] a management fee computed as a
percentage of gross revenuesâ as a factor suggesting that the partnership had a âsignificant profit-
making objectiveâ).
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Galenâs apparent conflict of interest is only partly mitigated by the fact that Section 3.2 of the
Partnership Agreement requires the manager to abide by the community benefit standard. As the
Government points out, that requirement is useful only to the extent that the governing documents
of the partnership empower St. Davidâs to enforce the provision. St. Davidâs appears to assert that
the primary means through which it can force Galen to comply with Sect ion 3.2 is by taking legal
action. Given the time and expense of judicial proceedings, we doubt that St. Davidâs will resort to
litigation every time Galen makes a single decision that appears to conflict with the community benefit
standard.
St. Davidâs also asserts that it can control the management of the partnership via its position
on the Board of Governors. However, the power of the Board is limited in scope. The Board of
Governors is empowered to deal with only major decisions, not the day-to-day operation of the
partnership hospitals.14 Thus, St. Davidâs could not, via its position on the Board, overrule a
management decision that fell outside the range of the Boardâs authority.
The Management Services Agreement does appear to provide St. Davidâs with a certain
degree of control over Galen. The agreement permits St. Davidâs to unilaterally cancel the contract
with Galen if the manager takes action that has a âmaterial probabilityâ of undermining St. Davidâs
tax-exempt status. It is not entirely clear whether St. Davidâs would be willing to exercise this
termination option without the consent of HCA. Nor is it clear whether St. Davidâs could ensure that
Galen was replaced by a manager that would prioritize charitable purposes. Nonetheless, the
14
The Board can consider matters such as: (1) amendments to the Partnership Agreement,
the Management Services Agreement, and other major partnership documents; (2) sales of
substantially all partnership assets; (3) approval of annual operating and capital budgets; (4) the hiring
the partnershipâs CEO; (5) any change in the mission of the partnership; and (6) authorization of debt
in excess of 10% of the partnershipâs assets. See Partnership Agreement, section 8.4(c).
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Management Services Agreement does appear to give St. Davidâs some authority over Galen, and
therefore seems to provide St. Davidâs with a degree of control over partnership operations.
We are also uncertain about the amount of control that St. Davidâs exercises over the
partnershipâs CEO. St. Davidâs appears to assert that its authority to appoint the initial CEO, and
its power to terminate the officer, demonstrate its control within the partnership. The Government
has created a general issue of material fact, however, regarding St. Davidâs by pointing to instances
in which the CEO failed to comply with the Partnership Agreement. Although the Partnership
Agreement states that the CEO âshallâ provide the Board of Governors with annual reports of the
amount of charity care, see Partnership Agreement, section 8.4(f), it seems that no such report was
prepared for 1996 (the first year of the partnership and the tax year at issue in this case). Indeed, it
does not appear that any annual report on charity care was prepared until after the IRS began auditing
the partnership. Despite St. Davidâs assertions about its power over the CEO, the non-profit does
not claim to have taken any punitive action against the CEO for failing to prepare these reports. If
St. Davidâs was in fact unable to enforce a provision of the Partnership Agreement dealing specifically
with charity care, that raises serious doubts about St. Davidâs capacity to ensure that the partnershipâs
operations further charitable purposes.
Finally, we question the degree to which St. Davidâs has the power to control the partnership
by threatening dissolution. First of all, the Partnership Agreement appears to permit St. Davidâs to
request dissolution only when there is a change in the law, not simply when the partnership fails to
perform a few charitable functions. See Partnership Agreement, section 15.1(f) (indicating that the
partnership âshallâ be dissolved upon â[t]he request of [St. Davidâs] for dissolution . . . in the event
[St. Davidâs] receives an opinion of counsel, from counsel reasonably acceptable to [St. Davidâs] and
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the [HCA] Governors, that as a result of a rule, regulation, statute, Internal Revenue Service
government pronouncement, or court decision . . . enacted or issued subsequent to the date hereof
which would cause the participation of [St. Davidâs] or the [St. Davidâs] Affiliates in the Partnership
to be inconsistent with [their] Status . . . as organizations described in Section 501(c)(3) of the
Codeâ). Second, HCA may not take seriously any threat of dissolution made by St. Davidâs. HCA
must be aware that St. Davidâs has a strong incentive not to exercise its power to dissolve the
corporation. The partnership documents include a non-compete clause, which provides that, in the
event of dissolution, neither partner can compete in the Austin area for two years. See Contribution
Agreement, section 11.1. That result might be slightly unpleasant for HCA, but would not destroy
the entity; HCA would still have its nationwide health care business. For St. Davidâs, by contrast,
dissolution would be disastrous. St. Davidâs serves only the Austin community. If it were forbidden
from competing in that area, St. Davidâs would (in effect) cease to exist. In light of the realities of
the situation, it seems unlikely that St. Davidâs would exercise its option to dissolve the partnership
even if the partnership strayed from St. Davidâs charitable mission.
The evidence presented by the parties demonstrates that there remain genuine issues of
material fact regarding whether St. Davidâs ceded control to HCA. Therefore, we vacate the district
courtâs grant of summary judgment in favor of St. Davidâs.15
For the above reasons, we VACATE the district courtâs summary judgment ruling and its
award of attorneyâs fees and costs and REMAND for further proceedings.
15
Because we vacate the district courtâs judgment, we need not address the other issue
presented by the instant case: whether the district court abused its discretion in awarding attorneyâs
fees and costs to St. Davidâs. Because St. Davidâs is no longer the prevailing party in this matter, it
is not entitled to fees or costs. See 26 U.S.C. § 7430(c)(4)(A) (indicating that only the âprevailing
partyâ is entitled to costs).
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