Cloud of uncertainty over non-profit HMOs

This fall the U.S. Supreme Court will decide whether to hear a case of great interest to the $1 trillion non-profit healthcare industry: whether that sector, especially non-profit HMOs, will continue to qualify for tax-exempt status.

In 2002, the Internal Revenue Service stripped Vision Service Plan — a national HMO that reimburses for optometry services not covered by most medical plans — of the tax-exempt status it had enjoyed for 42 years, notwithstanding that there had been no change in the applicable laws or regulations and no change, VSP maintains, in its business model.

“This is, in essence, an attack on the non-profit HMO model,” says former independent counsel Ken Starr, who filed VSP’s petition seeking Supreme Court review of the case last month, and who says he expects the Court to rule on the petition in November.

Starr maintains that the case “far transcends VSP,” and is being “very closely watched” throughout the entire non-profit healthcare industry. Starr is now of counsel at his long-time law firm Kirkland & Ellis, as well as dean of the Pepperdine Law School.

Of course, it’s Starr’s job to hype the case — it’s one way to try to persuade the Supreme Court to hear it — but Thomas K. Hyatt, the co-author of the treatise The Law of Tax-Exempt Healthcare Organizations, confirms in an interview that VSP’s case has created significant “problems in the field,” and that it tees up important issues for “all nonprofits arranging for healthcare, which is the way most modern HMOs operate.” By “arranging for healthcare,” Hyatt means those HMOs that send enrollees to networks of participating healthcare providers, rather than requiring that they see staff doctors actually employed by the HMO itself. (Hyatt is a partner at the Baltimore-based Ober Kaler law firm.)

Historically, Hyatt explains, most non-profit HMOs have been eligible for tax-exempt status either under 501(c)(3) or 501(c)(4) of the Internal Revenue Code. Those that used their own staffs of doctors, like Kaiser-Permanente, could often qualify for (c)(3) status, which, unlike (c)(4) status, not only confers exemption from income tax but also provides that donations to the organization will be tax-deductible. Other HMO business models, however, like those that use contracting networks of doctors, could still usually qualify for 501(c)(4) tax exemption, which is what VSP had enjoyed since 1960. (Under the regulations, to qualify for 501(c)(4) status, an organization must be “primarily engaged in promoting … the common good and general welfare of the people of the community.” In the past, providing healthcare services was, itself, considered a service to the community.)

In 1986, Congress amended the law to strip providers of “commercial-type insurance” of their tax-exempt status, in a move that was targeted at many Blue Cross insurers, which were felt to be getting an unfair advantage over their for-profit competitors while operating, in practice, in almost identical ways. But that legislation contained a safe-harbor provision that was widely understood to preserve the tax-exempt status of most nonprofit HMOs. (The provision specifies that “commercial-type insurance” won’t include “incidental health insurance provided by a health maintenance organization of a kind customarily provided by such organizations.”)

VSP continued to enjoin its exemption for another 13 years, but in 1999, shortly after the company expanded from a regional to a national operation, the Internal Revenue Service opened an inquiry into its status. In 2002, without making clear whether the 1986 amendment played any role in its thinking, the IRS revoked VSP’s tax-exemption, effective Jan. 1, 2003, explaining that a nonprofit health care provider that limits its benefits to a class of subscribers (its enrollees) would no longer be eligible for tax exemption unless it also provided some unspecified amount of additional “community benefits.” (Since more than 40% of VSP’s enrollees were participants in Medicaid, Medicare, or comparable state-sponsored programs, and VSP was contributing millions of dollars worth of services each year to charities like Sight For Students, VSP claims that the IRS’s determination was vague and arbitrary.)

VSP began paying taxes in 2003, but it also filed suit that year to recover those taxes. In December 2005, U.S. District Judge Lawrence Karlton of Sacramento ruled for the IRS in an opinion that stressed that VSP was not an actual provider of healthcare services, but an “arranger” of such services. (While this fact had previously been seen as a factor disqualifying an organization from (c)(3) status, it had not been previously thought to disqualify an organization from (c)(4) status.)

Judge Karlton did not discuss the 1986 amendment or its safe harbor. Instead, he focused on the commercial manner in which VSP operated. (Under IRS regulations, an organization isn’t being operated primarily to promote social welfare if it is being operated “in a manner similar to organizations which are operated for profit.”) Judge Karlton emphasized, for instance, that the company earned $34.5 million in net income in 2003 and that the company’s top executives received bonuses drawn from that net income. He also noted the relatively high salaries of its top executives (the CEO had received $395,000 plus bonuses in 2003) and that they enjoyed perks like the use of a “luxury company car.”

VSP appealed to the U.S. Court of Appeals for the Ninth Circuit, which then affirmed in a terse, opaque, three-paragraph ruling that did not discuss the 1986 amendment, its safe harbor, or either issue Judge Karlton had focused upon. Instead, the three-judge panel ruled that VSP was not “primarily engaged in promoting . . . the common good and general welfare of the people of the community” because it was primarily organized to benefit its own “subscribers rather than the general welfare of the community.” The Ninth Circuit’s ruling was also “unpublished,” meaning that, notwithstanding all the attention nonprofit lawyers around the country had been giving the crucial case in hopes of receiving guidance to pass along to clients, lawyers were not supposed to treat the ruling as carrying precedential weight.

VSP’s Supreme Court counsel Starr filed its certiorari petition in August, and last week it received amicus brief support from, among others, the three charities with which it partners in its Sight For Students program: Prevent Blindness America, the National Association of School Nurses, and the National Council of La Raza. The government, represented by assistant to the Solicitor General Gregory G. Garre, is expected to file a response on Oct. 10.

At stake, Starr asserts, is whether the IRS — without having received any direction from Congress — will succeed unilaterally in “driving the healthcare system to a for-profit business model, even though it’s universally agreed that non-profit has been a very efficient and successful model.”

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