November 1, 2024, Covington Alert
In a unanimous decision, the U.S. Court of Appeals for the Fifth Circuit affirmed the Tax Court’s denial of tax-exempt status for Memorial Hermann Accountable Care Organization (MHACO) as an organization described in section 501(c)(4) of the Internal Revenue Code. The decision could have implications for lobbying, political, and member-related activities of social welfare organizations.
Background
As a Texas nonprofit corporation, MHACO provides healthcare to patients under either its “Medicare Shared Savings Program” (MSSP), which specifically benefits Medicare patients, or under employer-sponsored commercial insurance plans.
MHACO applied to the IRS for recognition as a 501(c)(4) organization. The IRS issued a final adverse determination letter, stating that MHACO did not meet the requirements for tax-exempt status of operating exclusively for social welfare purposes because its activities primarily benefitted commercial payors rather than the public.
Legal Issue
The crux of the issue is the permissible threshold of so-called “nonexempt” activity that an organization may engage in and still qualify for exemption. Under one, narrower, legal standard—referred to as a “substantial nonexempt purpose” test and based on the Internal Revenue Code and a 1945 Supreme Court case—the presence of a single substantial nonexempt activity disqualifies an organization from exemption. Under a second legal standard—referred to as the “primary purpose” test and based on the Treasury Regulations—as long as an organization is primarily engaged in exempt activity, it will qualify for exemption. Stated another way, the primary purpose test permits a higher level of nonexempt activity: To the extent the nonexempt activity is not the organization’s primary activity, the organization will qualify for exemption under this second test.
Fifth Circuit Decision
The Fifth Circuit rejected MHACO’s argument regarding the applicable legal standard, affirming the use of the substantial nonexempt purpose test. The court relied on Loper Bright (the recent Supreme Court decision that held that courts are no longer required to provide “Chevron deference” to an agency’s rulemaking) to disregard the Treasury Regulation relied upon by MHACO when it argued for the primary purpose test.
After applying the substantial nonexempt purpose test, the court ultimately concluded that MHACO did not operate for the promotion of social welfare. Although MHACO argued that its services improved healthcare quality and reduced costs for the broader community, the court noted that the majority of its activities benefited its private members—primarily commercial payors—rather than the uninsured or the broader community. As such, MHACO, according to the court, engaged in more than an insubstantial amount of nonexempt activity.
Interestingly, in a footnote, the court said that applying either test to MHACO would produce the same result.
Implications
A threshold question is what portion of an organization’s activities must be for a social welfare purpose in order for the organization to qualify for exemption. For over a decade, many 501(c)(4) organizations have taken the position that “primarily” means at least 51 percent. The corollary to that position is that up to 49 percent of an organization’s activities may be in furtherance of a non-social welfare, or nonexempt, activity, such as political activity. This position is supported by the Treasury Regulations, precedential IRS rulings, and other IRS documents.
The court’s decision seemingly contravenes this position: An organization that primarily engages in social welfare activities but also engages in nonexempt activity may no longer qualify for exemption.
But the court’s decision does not address outstanding issues for 501(c)(4) organizations:
- Is there a bright line test or a safe harbor with respect to the permissible level of nonexempt activities that provides guidance to 501(c)(4) organizations?
- Given the Fifth Circuit’s disregard of the Treasury Regulations, is direct or indirect participation or intervention in political campaigns still considered a nonexempt activity of a 501(c)(4) organization, as set forth in the Treasury Regulations?
- How is nonexempt activity measured? The court referred to both MHACO’s operations and its revenue to conclude that it is not entitled to tax-exempt status.
- Congress has prohibited Treasury from finalizing regulations that provide clearer guidance with respect to political activity, and this court disregarded existing regulations in its decision, which results in uncertainty as to what the relevant parameters are and whether an organization is operating within those parameters.
While the Fifth Circuit’s decision is binding only in three states (Mississippi, Louisiana, and Texas), it is possible that other circuit courts will follow the decision. In addition, it is likely that the IRS will follow the decision because it has taken the same position in its briefing with respect to this case. There is also a possibility for the Fifth Circuit to agree to a rehearing (if brought by Memorial Hermann), which would result in another review.
But, this issue is not isolated to the Fifth Circuit. Another case involving a 501(c)(4) organization is currently pending in the U.S. District Court for the District of Columbia. In that case, Freedom Path, Inc. argues that the IRS should not have denied tax-exempt status based on the organization’s independent-expenditure political speech because such speech promotes social welfare within the meaning of section 501(c)(4). The issue in this case similarly relates to the permissible amount of nonexempt activity and the legal standard applicable to 501(c)(4) organizations.
These cases have implications for 501(c)(4) organizations that engage in nonexempt activities, such as lobbying, political campaign intervention, and member-specific activities. We recommend consulting with counsel to discuss the specific impact of this decision on your organization’s activities. If you have any questions concerning the material discussed in this client alert, please contact the members of our Tax practice.