September 2011 Volume 8 Number 1

Tax Exempt Issues for Accountable Care Organizations

By Douglas M. Mancino, Hunton & Williams LLP, Los Angeles, CA

AuthorThe Medicare Shared Savings Program (“MSSP”) was enacted as part of the Patient Protection and Affordable Care Act (“PPACA”) to promote accountability for care, coordination of services and the development of infrastructure to provide high-quality and efficient healthcare services to Medicare beneficiaries.1 Providers throughout the country are working diligently to develop shared governance structures that meet criteria specified by the Department of Health and Human Services (“HHS”) to participate as accountable care organizations (“ACOs”) under the MSSP. Many providers are also responding to or anticipating demands for ACOs to enter into shared savings contracts or other incentive payment arrangements with commercial payors. In fact, the MSSP expressly authorizes HHS to give preference to ACOs that are participating in similar arrangements with other payors.

Tax-exempt hospitals described in section 501(c)(3) of the Internal Revenue Code represent approximately two-thirds of the nation’s hospitals and many of them are among the providers working to establish ACOs for purposes of contracting with Medicare and commercial payors. Among the many issues that tax-exempt hospitals will have to consider in establishing ACOs are (i) whether the activities of the ACO are in furtherance of its charitable purposes, so that income from the ACO can be treated as related business income not subject to income tax, or if the ACO can separately apply for tax-exempt status; and (ii) whether participation in the ACO is structured so as not to result in any inurement or impermissible private benefit to other parties participating in the ACO that would compromise a party’s tax-exempt status or result in tax penalties.

Reviewing the guidance issued by the Internal Revenue Service (“IRS”) in Notice 2011-20 is an important first step in understanding how the IRS will evaluate a tax exempt hospital’s participation in an ACO that includes community physicians.2 This Notice, however, sends some mixed messages with regard to the tax treatment of revenues derived from ACOs contracting with commercial payors.

Section 1899 of the Social Security Act added by PPACA lists those combinations of providers and suppliers eligible to form an ACO. Each combination contemplates the involvement of physicians and other healthcare professionals to a significant degree in the ACO’s governance. Section 1899 also establishes several requirements for an ACO to participate in the MSSP, including that the ACO must include sufficient primary care ACO professionals for the number of Medicare fee-for-service beneficiaries assigned to the ACO, which will be at least 5,000 beneficiaries. Notice 2011-20 indicates that the IRS believes that, absent inurement or impermissible private benefit, an ACO’s participation in the MSSP would be consistent with the charitable purpose of lessening the burdens of government. In fact, Notice 2011-20 cites Revenue Ruling 81-276 in which the federal government considers the provision of Medicare benefits to be its burden and observes that Congress established the MSSP to be conducted through ACOs to promote quality improvements and cost savings, thereby lessening the government’s burden associated with providing Medicare benefits.3 Notice 2011-20 indicates that Medicaid shared savings arrangements may also further the charitable purpose of relieving the poor and distressed.

Despite these welcome indications, the IRS was strangely evasive when it comes to ACOs that contract with commercial payors. After noting that, in contrast to activities conducted as part of the MSSP, many non-MSSP activities conducted by or through an ACO are unlikely to lessen the burdens of government, Notice 2011-20 appears to suggest that negotiating with private health insurers on behalf of unrelated parties generally is not a charitable activity even if the agreement negotiated involves a program aimed at achieving socially desirable quality improvements and cost savings for healthcare services, which may likely be in coordination with the MSSP. This suggestion is puzzling since the IRS has previously issued private letter rulings dealing with gain-sharing arrangements4 and the tax treatment to hospitals of capitation payments from commercial payors5and in both cases concluded that they were related to the exempt purpose or function of the hospitals that requested such rulings. This apparent position by the IRS is further puzzling in light of language in PPACA that authorizes a contracting preference for MSSP ACOs that contract with private payors.6 Moreover, unlike the focus of gain-sharing and capitation arrangements in the 1990s and 2000s, most ACOs contracting with commercial payors are likely to direct their focus on quality improvement and care management in addition to cost reduction, as envisioned under the MSSP, further distinguishing them from traditional physician-hospital organizations.

As PPACA and the proposed MSSP regulations contemplate,7 an ACO eligible to participate in the MSSP need not be a separate legal entity formed by the tax-exempt hospital but, rather, can be a division of the tax-exempt hospital that puts in place the various internal organizational and operational criteria and systems called for by the MSSP. Yet many tax-exempt hospitals and health systems will find it desirable – if not essential – to form a separate legal entity in order to address the desire of participating physicians to have a meaningful, fiduciary-type role in the design, implementation, governance and operation of the ACO, whether it participates in the MSSP, contracts with commercial payors or does both. Forming a separate legal entity to serve as the ACO permits the establishment of a governance structure consistent with the requirements of the MSSP without having to reorganize the current governance structure of the tax-exempt hospital participating in the ACO.

Many tax-exempt hospitals and health systems working to develop ACOs may default to using the familiar form of the nonprofit membership corporation with shared governance that is often utilized for physician-hospital organizations.8 However, a nonprofit membership corporation is not automatically exempt from federal and state taxes and would be subject to federal income tax absent a tax exemption determination from the IRS, which may have its challenges based on Notice 2011-20. An alternative approach is for the hospital or health system to establish a single member limited liability company (“LLC”) to serve as the ACO. The single member LLC would be a separate legal entity for state law purposes and for purposes of contracting with Medicare and commercial payors, but it will be a disregarded entity for federal income tax purposes.9 Thus, there would be no need to apply for separate tax-exempt status for the LLC, and the tax-exempt hospital or health system member will have a strong case for treating any net income it derives from the operation of the LLC as income from a related trade or business based on well-established tax principles, irrespective of whether the LLC is participating in the MSSP or is formed solely for the purpose of contracting with commercial payors.

Notice 2011-20 also indicates the IRS is concerned about potential inurement of net earnings or impermissible private benefit to physicians participating in an ACO resulting from disproportionate sharing of savings or other factors. However, Notice 2011-20 also indicates these concerns will likely be allayed because an ACO that participates in the MSSP will be subject to significant regulation and oversight; provided that (i) the terms of the tax-exempt hospital’s participation in the ACO are set forth in advance in a written agreement, (ii) the tax-exempt hospital’s share of economic benefits derived from the ACO is proportional to the contributions made to the ACO, (iii) the tax-exempt hospital’s share of losses from the ACO does not exceed the share of benefits to which it is entitled, and (iv) arrangements between the ACO and other participants are at fair market value. With respect to ACOs that contract with commercial payors, tax-exempt hospitals and health systems should feel reasonably confident that inurement and private benefit concerns will be addressed adequately if their contractual terms allocating shared savings – negotiated at arm’s length with commercial payors – are similar to those under the MSSP and if arrangements with participating physicians are at fair market value.

Notice 2011-20 provides important insight as to how the IRS will evaluate a tax-exempt hospital’s participation in an ACO that includes community physicians. When structuring ACOs to contract with commercial payors, tax-exempt hospitals may want to consider using a single-member LLC structure to avoid the need to apply for a separate tax exemption determination from the IRS and should pay close attention to the shared savings mechanisms for participating physicians utilized under the MSSP.


Pub. L. No. 111-148, § 3022 and § 10307, 124 Stat. 119, 395-99 and 940-41 (March 23, 2010).

2 Notice 2011-20 is available at
3Rev. Rul. 81-276 is available at

See e.g., 1999 Tax Notes Today 128-39 (July 1, 1999).


See e.g. Priv. Ltr. Rul. 200044039 (August 3, 2000).


See Pub. L. No. 111-148 at § 10307, 124 Stat. at 941.


See Medicare Program; Medicare Shared Savings Program: Accountable Care Organizations Proposed Rule, 76 Fed. Reg. 19528, 19540 (April 7, 2011).


A nonprofit membership corporation is typically a corporation no part of which is distributable to its members, directors or officers, but which has members with certain voting or other governance rights as set forth in its governing documents. See e.g. American Bar Association Model Nonprofit Corporation Act, Third Edition (adopted August 2008). Nonprofit membership corporations are commonly used to allow for shared governance rights by a group of members, such as hospital and physician members of a physician-hospital organization.


A single-member limited liability company may elect to be treated as a disregarded entity or a branch or division of its owner for federal tax purposes. See IRS Form 8832.

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