IRS Ruling Threatens Future of Commercial ACOs, Cost-Reducing Healthcare Providers

Connie Zhang
Associate Editor
Loyola University Chicago School of Law, JD 2018


Your healthcare may come from an accountable care organization, and you may not even know it.

That could soon change now that the IRS has denied one commercial accountable care organization (ACO) the tax-exempt status granted to most nonprofit health care providers. The three major compliance concerns in the healthcare field are the Anti-Kickback Statute, the Stark Laws, and tax exemption. On April 8, 2016, when the IRS denied a commercial ACO 501(c)(3) tax-exempt status, it was deprived of a tremendously valuable asset.

In 2002, tax exemption alone saved hospitals $12.6 billion in federal, state, and local taxes ($16.1 billion in 2012 dollars). Since 2011, over 744 ACOs have been formed in the public and private sector serving over 23.5 million Americans. Of that number, only 7.8 million are part of the government’s Medicare ACO program, leaving the majority of patients under the commercial ACO umbrella.

The IRS’s adverse determination is the first enforcement of the charitable organizations standard for a commercial ACO, calling into question the viability of the healthcare model moving forward.

Accountable Care Organization

An ACO is a network of physicians, hospitals, and other health care stakeholders that is jointly “accountable” for every patient’s care. The lynchpin of every ACO is the primary care physician, who collaborates with specialists and hospitals in the network, and directs the entirety of a patient’s care from the initial visit onwards. Rather than shuffling a patient from one unrelated health provider to another, the ACO is a railroad connecting all the “stops” for evaluation and treatment a patient may need to make. Instead of contracting individually with each “train station” (hospital, outpatient facility, specialist), primary physicians are employees of the ACO – which may consist of an insurer, a physician group, and a hospital jointly accountable for the health outcomes and costs of providing care for individual patients.

The members of an ACO rise and fall together. The Affordable Care Act created the Medicare Shared Savings Program (MSSP) specifically to discourage physicians from unnecessary spending for tests and procedures. When an ACO operates at peak efficiency – cutting out administrative redundancies, trimming overhead, and sharing all medical data – providers will, in theory, reap a surplus. The status quo of running deficits promotes consolidation into too-big-to-fail health systems or cost-shifting onto private payers in order to remain afloat. However, under MSSP, ACOs are offered financial incentives for keeping costs down. The traditional fee-for-service payment system, where providers are paid for each test and procedure, promotes more-is-better spending whereas an ACO is paid more for keeping patients healthy. Savings generated are shared between the ACO and Medicare. In 2014, 97 ACOs qualified for shared savings of $422 million.

IRS Tax Exemption Status

The Affordable Care Act (ACA) did not create a separate tax-exemption for ACOs. Instead, ACOs must meet the general criteria under section 501(c)(3). If an ACO does not, then income accrued from that ACO may become “unrelated business” taxable income for member tax-exempt organizations (e.g. a nonprofit hospital taking part in the shared financial incentives of the ACO).

In 2011, the IRS ruled that an ACO enrolled in Medicare’s ACO scheme (MSSP) providing contracts and services to patients is tax-exempt because it furthers the charitable purpose of lessening the burdens the government must bear. However, this past April, the IRS found that a non-MSSP ACO existing solely to contract with providers and negotiate shared services with third-party providers did not further that charitable purpose, neither promoting health nor lessening government burdens.

Relying on precedent, the IRS considered a single nonexempt purpose, if substantial in nature, to destroy the exemption. A classic illustration of the principle is that of a pharmacy which may promote health through selling prescriptions but, if not operated for that exclusive purpose, will not qualify. There is the additional prohibition that net earnings may not inure to the benefit of any private shareholder or individual. In this case, the IRS found the primary beneficiaries of the ACO’s activities to be its members alongside physicians not even employed by the ACO. It was not the patient community or the government that reaped the benefits of lower costs through collective bargaining. Although a commercial ACO is not automatically disqualified from tax-exemption, it will be if its private benefits are not merely incidental or the necessary outcome of activities benefiting the public at large.

The ACO argued that its purpose was to further the ACA’s “Triple Aim” of cost reduction, better access, and population health, but the IRS rejected that reasoning on the grounds that negotiating shared services agreements and commercial contracting on behalf of both itself and independent, non-ACO members neither promoted health nor lessened the burdens of government. The ACO’s activities were too far removed from community benefit. Pursuant to this ruling, commercial ACOs will need to carefully examine their financial structure and purpose lest their tax-exempt members find themselves subjected to taxation of ACO income as unrelated business income.

What Now?

The Affordable Care Act championed the ACO model as a critical savings-generating health care delivery and payment model. Given that the vast majority of ACOs are commercial in nature, taxation may wipe out any savings generated resulting in little or even no benefit to patients. Prior to this ruling, some in the industry had projected future ACO growth to cover over 70 million people by 2020 and more than 150 million by 2025.

ACOs created solely to simplify contractual negotiations and use collective bargaining to lower costs should consider themselves on notice that their tax exemption status is at risk. An ACO will need to implement stricter audit policies to ensure that third parties are not the primary beneficiaries of its services. There also needs to be movement away from merely cost-cutting to more direct services or benefits provided to the community, particularly if they do not participate in Medicare’s ACO program.

Moving forward, the IRS has cast a shadow on the longevity and efficacy of this model unless commercial ACOs can adapt to comply with this new wrinkle in the tax exemption landscape by removing independent, third-party beneficiaries, restructuring their activities to directly meet a charitable purpose, and showing more clearly that any private inurement is incidental compared to the public benefit.