1 The term health maintenance organization or HMO was coined by Dr. Paul M. Ellwood, Jr., who is credited with drafting the Nixon administration’s proposel for HMO legislation. Havighurst, , Health Maintenance Organizations and the Market jor Health Services, 35 Law & Contemp. Prob. 716, 719 n.10 (1970)Google Scholar.

2 In 1965, there were only 20 HMOs serving 1.5 million subscribers, but in 1975, there were 175 HMOs serving 6 million subscribers. U.S. Dep’t of Health, Education And Welfare, Health Maintenance Organizations: 1975 Annual Report 1 (1975) at 89, 91. As of August 30, 1978, there were 203 HMOs serving 7.5 million subscribers. U.S. DEP’t OF Health, Education And Welfare, Health Maintenance Organizations: 1978 Annual Report 4, at 3, (DHEW Pub. No, (PHS) 79-13058 (1978)) [hereinafter cited as 1978 Annual Report].

3 Title XIII of the Public Health Service Act, Pub. L; No. 93-222, 87 Stat. 936 (enacted 1973, amended 1976, 1978, codified at 42 U.S.C.A. §§ 300e - 300e-17 (West 1974 & Cum: Supp. 1974-78)) and accompanying regulations at 42 C.F.R. §§ 110.101 - 110.907 (1979). For legislative history and purpose of the Act and amendments see [1973] U.S. Code Conc. Fe Ad. News 3033, [1976] U.S. Code Cong. & Ad. News 4312 and [1978] U.S. Code Cong. & Ad. News 4935.

4 When an HMO is qualified, area employers must offer employees in their health benefit plans the option of membership in the HMO. This statutory mandate is a great boost to HMO enrollment, 42 U.S.C.A. § 300e-9 (West Cum. Supp. 1974-78).

5 These services consist of “basic health services’,” including physician services, inpatient and outpatient hospital services, emergency health services, short-term mental health services, alcohol and drug abuse treatment, diagnostic services, home health services, and preventive health services such as immunizations, children’s eye and family planning services. In addition, HMOs offer “supplemenal health services” including long-term care, vision care, dental services, mental health services, rehabilitative services, and prescription drug services. 42 U.S.C.A. § 300e-l(l) & (2) (West Cum. Supp. 1974-78).

6 To qualify under the HMO Act, the organization must offer enrollment to persons who are broadly representative of the various age, social and income groups within the geographical area served. 42 U.S.C.A. § 300e(c)(3)(A) (West Cum. Supp. 1974-78). An HMO may not expel or refuse to re-enroll any member because of his or her health status or health care needs. 42 U.S.C.A. § 300e(c)(5) (West 1974). At least for HMOs with over 50,000 members or in operation over five years, there must be an open enrollment period for individual members of 30 days or until there is a 3 per cent increased enrollment. 42 U.S.C.A. § 300e(d) (West Cum. Supp. 1974-78). Furthermore, during open enrollment periods, members must be accepted without regard to preexisting illness, with an exception for those who have been confined to an institution because of chronic illness or permanent injury and whose care, would economically impair the HMO. 42 U.S.C.A. § 300e(d)(l) & (2) (West Cum. Supp. 1974-78).

7 To qualify under the HMO act, the organization must provide its services in exchange for payments or premiums made by. members on a periodic basis and fixed without regard to the frequency, extent or kind of services actually rendered. These premiums are determined on the basis of a community rating or expected utilization of the entire membership. 42 U.S.C;A. § 300e-l(8) (West Cum. Supp. 1974-78).

8 At least one third of the board of directors must be consumers. 42 U.S.C.A. § 300e(c)(6)(A) (West Cum. Supp. 1974-78).

9 The staff model HMO is one in which physicians are salaried employees of the organization. The group practice HMO is one in which physicians are paid on a per patient basis. In IPAs (Individual Professional Associations) or HMOs “without walls,” health services are delivered by private practitioners in their own offices. 42 U.S.C.A. § 300e(b)(3)(A) (West Cum. Supp. 1974-78). The fact that an HMO operates without a common central facility, should not in and of itself, affect the tax exempt purpose of the organization. However, IPAs will not be discussed in this Note because the data for their cost savings is less consistent than that for the other two types of HMOs. Luft, , HMO Performance: Current Knowledge and Questions for the 1980s, 1 Group Health J. 34, 34 (1980)Google Scholar.

10 Some HMOs do not need federal funding or loan assistance, while others find the process and requirements of qualification too costly or burdensome. In 1978, only 69 of the 203 HMOs in the United States were federally qualified. 1978 Annual Report, supra note 2, at 55. As of March 3, 1980, 108 HMOs were federally qualified, 45 Fed. Reg. 13,892 (1980).

11 Although nonprofit HMOs by definition have no “profits,” they do receive membership premiums and other funds for operating capital and expansion financing that, but for an I.R.C. § 501 exemption, would be taxable.

12 Found Church of Scientology v. United States, 412 F.2d 1197, 1199 (Ct. Cl. 1969).

13 Bittker, & Rahdert, , The Exemption of Non-Profit Organizations From Federal Income Taxation, 85 Yale L.J. 299, 332 (1976)Google Scholar.

14 By statute a few HMOs were specifically granted 501(c)(3) status. See, e.g., Group Hospitalization, Inc., 53 Stat. 1412 (1939).

15 This “benefit theory” has been challenged. According to Bittker & Rahdert, supra note 13, charities are spared taxation because basic ideas of “income” and “business“ expense do not fit a nonprofit organization. There is no satisfactory way to measure success or profits, approximate tax rates, or figure “business” deductions of organizations that are not profit motivated.

HMOs conform with Bittker and Rahdert’s justification for tax exempt organizations because any “profits” received by an HMO in one financial year will be designated for expansion or improvement of the medical facilities and services or used to offset premium increases in subsequent years, instead of being distributed to shareholders or retained as earnings. HMOs do not conform entirely to the Bittker and Rahdert model of an exempt organization because HMOs receive their income in the form of premiums which are easily measurable, and are designed to provide comprehensive care at the lowest cost, which is comparable to profit maximizing. Therefore, the benefit approach provides a better justification for granting tax exempt status to HMOs than the Bittker and Rahdert approach.

16 Nonprofit HMOs are most frequently classified by the IRS under the catchall “social welfare” provision of § 501(c)(4) but no guidelines have been issued by the IRS to explain this tax treatment of HMOs. U.S. Dep’t of Health, Education And Welfare, Hmo Feasibility Study Guide 21 (DHEW Pub. No. (HSA) 74-132020 (1974)). See, McGovern, , Federal Tax Exemption of Prepaid Health Care Plans, 7 Tax Advisor 76, 80 n.25 (1976)Google Scholar. Mr. McGovern contends that the tax treatment of prepayment methods of health care delivery is an area of prevailing confusion that can best be remedied by legislative action.

17 Treas. Reg. § 1.508-l(a)(2)(ii) (1976) requires application by filing a 1023 Form.

18 The organizational test generally will not present an insurmountable problem and can be established by the articles of incorporation, charter and bylaws of the organization. See, e.g., John Danz Charitable Trust, 32 T.C. 469 (1959), aff’d, 284 F.2d 726 (9th Cir. 1960) (exempt even though trustees were empowered with nonexempt functions, as long as these functions were not exercised).

19 Tax exempt purposes are religious, charitable, scientific, testing for public safety, literary and educational. I.R.C. § 501(c)(3).

20 The operational test is somewhat more difficult. According to Treas. Reg. § 1.501(c)(3)-l(c)(l) (1976), an organization must engage “primarily in activities which accomplish one or more of such exempt purposes.” If any substantial part of an organization’s activities are not for a charitable or exempt purpose, it is not operated exclusively for that purpose. Harding Hospital, Inc. v. United States, 505 F.2d 1068, 1072 (6th Cir. 1974); Duffy v. Birmingham, 190 F.2d 738 (8th Cir. 1951); Better Business Bureau v. United States, 326 U.S. 279, 283 (1945).

21 Hospitals have had the most difficulty with this inurement . requirement. In several hospital cases, 501(c)(3) status was denied because benefits were found to inure to physicians and/or hospital owners or founders. Sonora Community Hospital, 46 T.C. 519 (1966), aff’d per curiam, 397 F.2d 814 (9th Cir. 1968); Harding Hospital, Inc. v. United States, 505 F.2d 1068 (6th Cir. 1974); W.H. Kenner v. Comm’r, 20 T.C.M. 185, aff’d, 318 F.2d 632 (1963); Fort Scott Clinic and Hospital Corporation v. Brobrick, 99 F. Supp. 515 (1951); Lowry Hospital Ass’n v. Comm’r, 66 T.C. 850 (1976); Maynard Hospital, Inc. v. Comm’r, 52 T.C. 1006 (1969); Lorain Avenue Clinic v. Comm’r, 31 T.C. 141 (1958).

22 For a general discussion of these requirements, see Broadway Theatre League of Lynchburg, Virginia, Inc. v. United States, 293 F. Supp. 346 (W.D. Va. 1968); Fisch, E., Charities and Charitable Foundations § 879 (1974)Google Scholar.

23 Treas. Reg. § 1.501(c)(3)-l(d)(l)(ii) (1976). :

24 Id.

25 See notes 49-82 infra and accompanying text.

26 Bromberg, Obtaining a 501(c)(i) exemption for an HMO should be easier now despite IRS objections, 51 J. OF TAX. 302, 302 (1979).

27 See note 11 supra and accompanying text.

28 See, e.g., Harding Hospital, Inc. v. United States, 505 F.2d 1068, 1071-75 (6th Cir. 1974) (where the court set forth in detail the various requirements for a hospital seeking 501 (c)(3) classification).

29 71 T.C. 158 (1978). The Tax Court decision was appealed by the government to the Ninth Circuit, but subsequently was dismissed. [1979 New Matters] 10 Stand. Fed. Tax Rep. (CCH) at 70,738. This dismissal may be indicative of a move by the IRS in favor of granting HMOs 501(c)(3) status.

30 In 1979, an estimated 8.3 million people or four percent of the population were enrolled in HMOs. Demkovich, , Cutting Health Care Costs - Why Not Let the Market Decide?, 1979 Nat’l J. 1796, 1797Google Scholar.

31 The Kaiser Foundation Health Plan, the second to be formed in the United States, serves more than three million members in six western states—one out of every ten citizens of California; employs 3,000 physicians and operates its own hospitals. It boasts that its members are in fact healthier and happier because they utilize 50 percent fewer hospital days per capita than the population as a whole and pay premiums that are typically comparable if not lower than available Blue Cross premiums. Sullivan, Health Maintenance Groups Take Growing Role As Resistance Eases, N.Y. Times, May 21, 1978, § 1, at 47, col. 2.

32 During the 11 year period from fiscal year 1960 to the end of fiscal year 1971, national health expenditures rose by 188 percent, from $26 billion in fiscal year 1960 to $75 billion in fiscal year 1971. S. REP. NO. 93-129, 93rd Cong.! 1st Sess., 1 (1973) reprinted in [1973] U.S. CODE CONG. & AD. NEWS 3033.

33 42 U.S.C.A. § 300e-8 (West Cum. Supp. 1974-78).

34 The Department of Health, Education and Welfare is now the Department of Health and Human Services.

35 As of the end of fiscal year 1978, the federal government, through the Department of Health, Education and Welfare, had awarded $74.5 million to qualified HMOs pursuant to the federal HMO law. 1978 Annual Report, supra note 2, at 22.

36 This “dual option” requirement for corporations with over 25 employees may be waived if no qualified HMO is nearby. 42 U.S.C.A. § 300e-9(a)(l) (West Cum. Supp. 1974-78).

37 See generally Havighurst, supra note 1; Kissam, & Johnson, , Health Maintenance Organizations and Federal Law: Toward a Theory of Limited Reformmongering, 29 Vand. L. Rev. 1163 (1976)Google Scholar.

38 Havighurst, supra note 1, at 720.

39 Hospitalization constitutes 80 percent of health costs; hence, hospital over-utilization is the single, most often asserted cause of increased health care costs. Sullivan, supra note 31, at 47, col. 1. In 1978, in group model HMOs, hospital inpatient days per 1,000 members per year were 449 and in staff model HMOs 405. The national average is 1,022 inpatient days per year. 1978 Annual Report, supra note 2, at 4.

40 According to Judge Magruder’s dissenting opinion in Hassett v. Associated Hosp. Serv. Corp., 125 F.2d 611, 617 (1st Cir. 1942), the prepayment feature enables persons “who otherwise might perforce neglect or defer needed care for their bodily ills, to the detriment of the public health, … to procure hospitalization when the need therefor is first manifested.“

41 Studies demonstrate that HMOs do lower costs. All of six studies conducted thus far uniformily support the claim that total costs, that is premium plus out-of-pocket expenditures, are lower for enrollees in prepaid group practices than for people in conventional health insurance plans. These studies indicate that HMO enrollees save between 10 percent and 40 percent on total health care costs. Luft, supra note 9, at 34.

Former HEW Under-Secretary Hale Champion has predicted that in this decade, HMOs will produce savings of $20 to $24 billion in national health care costs. He also predicted that HMOs would triple their enrollment in this decade to serve over 20 million subscribers. N.Y. Times, Feb. 13, 1979, at 16, col. 5.

42 in 1978, for example, the national amount reimbursed under Medicare alone was over $23 billion. Unpublished data from the Health Care Finance Administration, Office of Research, Demonstration and Statistics, Baltimore, Maryland.

43 In Group Health Cooperative v. King County Medical Soc’y, 39 Wash. 2d 586, 604; 237 P.2d 737, 747 (1951), the court summarized the’ advantages of a prepaid group practice plan as follows:

44 Other advantages for HMO staff physicians include shorter work weeks and more regular schedules than their counterparts in private practice. Luft, supra note 9, at 35.

45 Twenty-seven separate studies have compared quality of HMO care to quality of fee-for-service care. The quality of HMO care, as measured by factors including physician qualifications, continuity of care, accessibility, diagnostic accuracy and patient satisfaction, was found superior to fee-for-service care in 19 studies and similar to feefor- service care in the remaining 8 studies. No study reported HMO care to be inferior. Cunningham, & Williamson, , How Does the Quality of Health Care in HMOs Compare to that in Other Settings?, 1 Group Health J. 4, 13 (1980)Google Scholar.

46 Of the 203 HMOs caring for some 7.5 million Americans in 1978, more than twothirds served fewer than 25,000 subscribers. 1978 Annual Report, supra note 2, at 3, 100. But to break even, HMO experts claim, a prepaid health plan must enroll 30,000 persons and spend more than $2 million on marketing, staff and facilities over a threeyear period. Lublin, Unhealthy Start: Prepaid Medical Plans Run Into Difficulties As Enrollment Falters, Wall St. J., Feb. 11, 1975, at 31, col. 2. For example, New Jersey’s largest HMO, Rutgers Community Health Plan, has 23,000 members but will require 32,000 to break even, while New York City’s first HMO, Manhattan Health Plan, which is less than 2 years old, will require 21,000 members. Sullivan, supra note 31, at 47, col. 2.

47 Lublin, id. at 1, col. 1.

48 Healthcare, an HMO in Brooklyn organized by Connecticut General Life Insurance Co. of Hartford, Conn., was forced to close down on March 31, 1975 when only 400 of 12,000 expected subscribers joined. Healthcare’s $69.75 a month premium for a family of three or more exceeded some New York Blue Cross plans by as much as $30 monthly. (Blue Cross rates in New York tend to be kept low by state regulations.) Id.

49 Since 1975, financial data indicate that the total income of all HMOs has been increasing faster than total expenses. 1978 Annual Report, supra note 2, at 50-51. Many HMOs, however, still experience financial difficulties. For example, the HMO in Sound Health Association v. Comm’r, 71 T.C. 158 (1978), due to financial necessity, was recently absorbed by another HMO, Group Health of Puget Sound. 3 HMO Focus 3 (1980).

50 For example, Harvard Community Health Plan, Inc. (hereinafter HCHP), a 50 1(c)(3) classified HMO in Boston, Mass., received substantial grants during its initial years of operation from Rockefeller Foundation, Commonwealth Fund, Robert Wood Johnson Foundation and Surona Foundation. Interview with Claire McGuire, Legal Counsel for HCHP, in Boston, Mass. (March 21, 1980).

51 I.R.C. §§ 4940-4948 are the private foundation provisions. The tax imposed by § 4942 is equal to 15 percent of the amount of certain undistributed income of the private foundation. See generally, S. Weithorn, Private Charitable Foundations 2d (1971).

52 I.R.C. § 4942 is entitled “Taxes on Failure to Distribute Income.“

53 Pursuant to I.R.C. § 4945(h) and Treas. Reg. § 53.4945-5(d) (1973) private foundations subject to “expenditure responsibility requirements” must compile detailed annual reports concerning any amount that is paid as a grant to any non-501(c)(3) organization.

54 The term “qualifying distribution” is defined by I.R.C. § 4942(g). See S. Weithorn, supra note 51, at 255-86.

55 Pursuant to I.R.C. § 4942(g)(l)(A), a qualifying distribution is any amount paid to accomplish one or more of the purposes described as charitable in I.R.C. § 170(c)(2)(B), the provision on the deduction of charitable contributions. I.R.C. § 170(c)(2)(B) has the same language as I.R.C. § 501(c)(3), therefore distributions to 501(c)(3) organizations are qualifying distributions.

56 In addition, a private foundation, upon termination, will also seek a 501(c)(3) organization to receive its assets so that it may abate any tax imposed. I.R.C. § 507(g).

57 I.R.C. § 403(b) is entitled “Taxability of Beneficiary Under Annuity Purchase By Section 501(c)(3) Organization or Public School.” See, e.g. Azad v. United States, 388 F.2d 74 (8th Cir. 1968).,

58 I.R.C. §§ 401-415, entitled “Subchapter D—Deferred Compensation, Etc.,” provides for special compensation plans.

59 I.R.C. § 403(b)(2) permits an exclusion of certain amounts from gross income.

60 I.R.C. § 403(a)(4) permits rollover amounts to be excluded from gross income for the taxable year.

61 I.R.C. § 402(a)(2) permits certain amounts to be treated as gains from the sale or exchange of long-term capital assets.

62 I.R.C. § 3121(b)(8)(B) FICA tax.

63 I.R.C. § 3306(c)(8) FUTA tax.

64 I.R.C. § 3121(b)(8)(B) would increase salaries by as much as 12.26 percent in 1980 by avoiding the following taxes: a 5.08 percent tax on. employee wages (§ 3103(a)); a 1.05 percent tax on employee hospital insurance (§ 3I01(b)); a 5.08 percent excise tax on employer payment of wages (§ 3111(a)); and a 1.05 percent tax on employer payment of hospital insurance (§ 3111(b)). This maximum amount will increase to 14.10 percent by 1985.

65 There is an apparent contradiction implicit in the employers’ treatment of HMO contributions. If HMOs are granted 501(c)(3) charitable purpose status, but employers continue to treat their contributions as business expenses, it will appear that what one claims is charitable, the other claims is business. If employers deduct their contributions to 501(c)(3) HMOs as charitable deductions, the anomaly is of course eliminated. However, it can be argued that employers still may deduct contributions under § 162 and HMOs may still receive 501(c)(3) status. It is contended in this Note that an organization may serve a defined membership and still be classified as a 501(c)(3) organization. If a portion of that membership are employees of a particular firm, company, or corporation, that firm, or company should be justified in treating its contributions as business expenses. The perspectives for employer and employee are different and the tax requirements are different.

66 There are several IRC provisions that permit the deduction of contributions to 501(c)(3) organizations. I.R.C. §§ 170(a), (b) & (c)(2)(B) provide for the deduction of contributions from the taxable income of individuals and corporations. I.R.C. § 642(c) offers this deduction to estates or trusts, and I.R.C. § 702(a)(4) to partnerships. I.R.C. § 2522(a) provides for the deduction of contributions by individuals in computing taxable gifts. I.R.C. § 2055(a) permits the deduction of contributions in computing estate tax, I.R.C. § 2106(a) deducts contributions from any tax on the transfer of an estate, and I.R.C. § 2602(c)(2) deducts contributions from generation skipping tax.

Furthermore, percentage limitations on individual charitable contributions will be lower if the HMO is a 501(c)(3) organization. I.R.C. § 170(b)(l)(A)(iii) provides that charitable contributions to hospitals will be allowed as deductible contributions to the extent they do not exceed 50 percent of the taxpayer’s contributions based for, the taxable year. I.R.C. § 170(b)(l)(B) subjects other contribution deductions to more stringent limitations. In order for individual contributions to an HMO to be deductible to the maximum amount, the HMO must be considered a “hospital” for purposes of I.R.C. § 170(b)(l)(A)(iii). Granting 501(c)(3) status arguably is equivalent to granting the HMO “hospital” status for purposes of § 170(b)(l)(A)(iii). Therefore, if an HMO is granted 501(c)(3) status, it will also receive the less stringent contribution limitations of § 170(b)(l)(A)(iii).

67 Nor do contributions play a very important role in hospital financing. Charitable contributions are responsible for meeting only four percent of total health costs. Bromberg, , Financing Health Care and the Effects of the Tax Law, 39 Law & Contemp. Prob. 156, 158 (1975)Google Scholar.

68 Unions may encourage employers to assist in the establishment of HMOs by tax deductible contributions. Bromberg, , The Effect of Tax Policy on the Delivery and Cost of Health Care, 53 Taxes 452, 476 (1975)Google Scholar.

69 I.R.C. § 103(b)(3)(B) permits 501(c)(3) organizations to avoid the financing restrictions imposed by I.R.C. § 103(b) on industrial development bonds. These restrictions include user limitations, issue limitations and advance funding limitations.

70 I.R.C. §§ 509(a)(3) & 501(c)(3) permit mergers of two 50I(c)(3) organizations. Therefore, if the IRS decided to grant 501(c)(3) status to most HMOs, other 501(c)(3) organizations could set up HMOs without jeopardizing their own 501(c)(3) status. In Kansas, for example, the Truman Medical Center, a municipal 501(c)(3) hospital, was discouraged from implementing a plan to organize an HMO because the board of trustees of the hospital could not recommend, in conformity with their fiduciary obligations, a plan that might jeopardize the hospital’s existing 501(c)(3) status. Telephone Interview with James M. Matthews of Linde, Thomson, Fairchild, Langworthy & Kohn, Kansas City, Missouri (April 2, 1980).

Section 501(c)(3) status also would permit an HMO to participate in a 501(e) cooperative or consortium to share services.

See, e.g., Rev. Rul. 78-41, 1978-1 C.B. 148. A trust created by an exempt hospital to satisfy hospital malpractice claims was deemed to operate as an integral part of the hospital and, therefore, to be exempt from taxation under 501(c)(3).

71 I.R.C. § 4253(h) permits 501(c)(3) organizations to avoid the telephone service tax imposed by § 4251(a). HCHP, for example, saves $20,000 annually on telephone expenses. Interview with Claire McGuire, supra note 50.

72 See, e.g., Bromberg, supra note 68, at 476.

73 For example, the Michael Reese Health Plan, Inc. (hereinafter MRHP) in Illinois computes the savings as $3.00 per enrollee. Telephone interview with Daniel R. Swett of Sonnenschein, Carlin, Nath & Rosenthal, Chicago, Illinois (June 27, 1980).

74 In Illinois, for example, a federal tax exemption is not determinative of whether the organization is organized exclusively as a charity for state tax purposes. People ex rel. County Collector v. Hopedale Medical Foundation, 46 111. 2d 450, 264 N.E.2d 4 (1970). However, following a federal denial of charitable status, it would be difficult to persuade the state otherwise.

75 Massachusetts provides an example of this group. In Massachusetts, 501(c)(3) status serves only as evidence that the HMO is a “charitable“organization.” See, e.g. Mass. Gen. Laws Ann. ch. 59, § 5 (1978). For HMOs in these states, 501(c)(3) status tends to increase their chances of receiving a state tax exemption and to lessen their burdens of establishing this exemption in state proceedings.

76 Washington is typical of the states where 501(c)(3) status has absoluately no bearing on the determination of state property tax. See Wash. Rev. Code Ann. § 84.36.030 (1977).

77 State jurisdictions can be grouped into three types depending upon how 501(c)(3) status effects the determination of sales tax exempt organizations. As in the property tax exemption determination, some states regard a federal exemption as significant. The Missouri Department of Revenue, for example, regards federal tax exempt status as necessary, although not sufficient, for an exemption from state sales and use tax. This is not a statutory requirement, but reflects the policy of the Missouri Department of Revenue. Mo. Ann. Stat. §§ 144.040(1), 144.615(3) (Vernon 1969); 12 Mo. CSR 10-3.378(5) (1975). Others treat the federal determination as evidence of whether a state sales tax exemption should be granted. The third group regards the federal exemption as completely insignificant.

78 For MRHP in Illinois the savings from sales tax is approximately $5,000 to $10,000 annually or $1.00 per enrollee. Telephone Interview with Daniel R. Swett, supra note 73. HCHP saves about 570,000 annually on the purchase of supplies and equipment and saved $230,000 on the $7,000,000 renovation project of one Boston facility. Interview with Claire McGuire, supra note 50.

79 Certain states, Missouri for example, permit 501(c)(3) organizations to provide their own less expensive unemployment insurance instead of participating in the more expensive state unemployment compensation plans.

80 Some states allow 501(c)(3) organizations to pool their liablilities to obtain reduced insurance premium arrangements.

81 In Missouri, 501(c)(3) organizations receive a four percent reduction in building material costs. 12 Mo. CSR 10-3.388 (1975).

82 In addition, charitable organizations also receive special price advantages in the purchase of pharmaceutical supplies. Abbott Laboratories v. Portland Retail Druggist Association, 425 U.S. 1, 4 (1976).

83 I.R.C. § 7428 provides for an action for declaratory relief. Michael Reese Health Plan, Inc. v. Comm’r, No. 13314-78X is presently pending before the Tax Court. Two other declaratory judgments actions were recently dismissed when the IRS acquiesced and granted the HMOs 50I(c)(3) status. Prime Health, Inc. v. Comm’r, No. 12730-78X; Group Health Plan of New Jersey, Inc. v. Comm’r, No. 78-2244 (D.D.C. 1978). ‘

84 71 T.C. 158 (1978). See note 29 supra.

85 Treas. Reg. § 1.501(c)(3)-l(d)(l)(ii) (1976) provides:

An organization is not organized or operated exclusively for one or more of the purposes specified in subdivision (i) of this subparagraph [i.e. charitable] unless it serves a public rather than a private interest. Thus, to meet the requirement of this subdivision, it is necessary for an organization to establish that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests.

86 Sound Health Association v. Comm’r, 71 T.C. at 167-68.

87 71 T.C. at 191.

88 Hospital A in Rev. Rul. 69-545, 1969-2 C.B. 117 was a 250-bed community hospital with a full time emergency room where no person requiring emergency care was denied treatment. Otherwise, the hospital treated only those who could pay the costs of their hospitalization through insurance, Medicaid or any other means. Rev. Rul. 69-545 modifies the previous Rev. Rul. 56-185, 1956-1 C.B. 202, which required hospitals to provide services regularly for those unable to pay in order to obtain 501(c)(3) status. Thus, there are now two standards by which hospitals can gain 501(c)(3) classification. First, under the new community benefit standard of Rev. Rul. 69-545, a hospital can be exempted from taxes if it benefits the community by making available emergency room services to all and furnishing other hospital services to patients able to pay. Second, under the old financial ability standard of Rev. Rul. 56-183, a hospital can be exempted if it provides, to the extent of its financial ability, for those unable to pay. See, Sound Health Association v. Comm’r, 71 T.C. at 168, n.9 and Bromberg, supra note 67, at 156 for a detailed discussion of Rev. Rul. 69-545 and the community benefit standard.

89 The tax court stated that “[l]ike Hospital A, the Association [HMO] opened its emergency room to all persons requiring emergency care, whether they were financially able to pay or not, and whether they were members or not, and decided to make no charge to indigents for such care.” 71 T.C. at 178. William N. Mathias, III, who represented the Sound Health Association before the tax court, explains that the HMO did not have an emergency room but that it provided services to indigent persons without charge in an emergency situation; W. Mathias, the Sound Health Decision, 1979 Health Law Update—Proceedings of the National Health Lawyers Assoc. 189, 192 (J. Skiba ed. 1979). The distinction between providing emergency room care and operating an emergency room was confused by the court. Although the court discussed the HMO’s emergency services as evidence of how the HMO operated exclusively for a charitable purpose and served a community benefit, the court did not hold that operating an emergency room was the exclusive means of providing a community service. The court noted that the Sound Health HMO provided educational and research services that benefited the community, as well as.the emergency services.

90 71 T.C. at 184.

91 71 T.C. at 185.

92 See note 6 supra.

93 See, e.g., Sonora Community Hospital, 46 T.C. 519 (1966), aff’d per curiam, 397 F.2d 814 (9th Cir. 1968) (Section 501(c)(3) status was denied because profits were found to inure to the founding physicians).

94 See, e.g., Leon A. Beeghly Fund v. Comm’r, 35 T.C. 490 (1960) (Section 501(c)(3) status was denied because profits were found to inure to private stockholders).

95 Baltimore Regional Joint Bd. Health & Welfare v. Comm’r, 69 T.C. 554 (1978) (Section 501(c)(3) status was denied a prepaid medical care cooperative because membership was restricted to a particular union).

96 United States v. La Societe Francaise de Bienfaisance Mutuelle, 152 F.2d 243, 244 (9th Cir. 1945), cert, denied, 327 U.S. 793 (1946) (Section 501(c)(3) status was denied an organization providing medical, hospital and= surgical care because membership was limited to persons “of French birth, or descendants of French or speaking French …“).

97 The court in Sound Health, 71 T.C. at 190, contrasted the Sound Health Association with the organization in B.S.W. Group, Inc. v. Comm’r, 70 T.C. 352 (1978), which conducted a consulting business of the sort that is ordinarily carried on by commercial ventures organized for profit. Unlike business consulting services that are non-charitable, the promotion of health is a charitable pupose.

98 See note 14 supra.

99 Treas. Reg. § 1.501(c)(3)-(l)(d)(2) (1976). Green v. Connally, 330 F. Supp. 1150, 1151 (1971) (The term “charitable” in 501(c)(3) is not used in a street or popular sense such as benevolence to the poor and suffering.)

100 Treas. Reg. § 1.501(c)(3)-l(d)(2) (1976).

101 Some HMOs provide care to those unable to pay. Sound Health, for, example, had a special contribution arrangement, whereby those unable to pay their premiums could be subsidized by contributions. 71 T.C. at 182. HCHP, for example, has one facility that serves low-income members who use significantly more services than the rest of the membership. Members of this low-income group still pay the common overall community rate. In effect, the low-income members’ use is supported by other members’ premiums. Interview with Claire McGuire, supra note 50.

102 See note 45 supra.

103 For example, the Sound Health HMO conducted a research program to investigate ways to better utilize health and medical resources. 71 T.C. at 165.

104 For example, the Sound Health HMO established a public health program. 71 T.C. at 166. HCHP plans to formalize further its cosimunity service efforts by allocating 1.5 percent of its premiums to fund a foundation, controlled by a separate board of directors, which will support education and community service. This foundation will sponsor, among other things, a scholarship program. Interview with Claire McGuire, supra note 50.

105 Although there is no easy way to measure whether HMOs increase the quality of health care for non-HMO members, HMOs do compete with traditional health care providers in the communities they serve. If community members find they can receive better care at an HMO, the other health care providers will experience a decease in the demand for their services. Studies indicate that HMOs provide care that is comparable to, if not better than, traditional health care. See note 45 supra.

106 An 18-month study on the impact of HMOs on the health delivery field documented a correlation between the presence of HMOs and an awareness of costs by non-HMO doctors and hospitals. 32 Employee Benefit Plan Review 16 (1977). Thus, in areas served by HMOs, costs and hospital utilization can decrease for the overall population. For example, in Minneapolis-St. Paul, where nearly 300,000 people or 13.5 percent of the population belong to one of the region’s seven HMOs, HMO members are using hospitals by 30 to 60 percent less than before. Furthermore, hospital utilization by non-HMO members also declined. Blue Cross reported an 11 percent decline in hospital use for its Minnesota subscribers in 1978 and Medicare experienced a 10.7 percent decline in 1977. Demovich, supra note 30, at 1797.

107 Restatement (SECOND) OF TRUSTS §§ 368, 372 (1959); Bogert, Trusts and Trustees, § 374 (2d ed. 1969); SCOTT ON TRUSTS, §§ 368, 372 (3rd ed. 1967); Rev. Rul. 69-545, 1969-2 C.B. 117; Rev. Rul. 73-313, 1973-2 C.B. 174; Rev. Rul. 77-69, 1977-1 C.B. 143. See Bromberg, The Charitable Hospital, 20 CATH. U. L. REV. 237 (1970).

108 Treas. Reg. § 1.501(c)(3)-l(d)(2) (1976).

109 1969-2 C.B. 117. See note 88 supra.

110 “Relief of the poor and distressed or of the under priveleged” is enumerated as a charitable purpose by the Income Tax Regulations. Treas. Reg. § 1.501(c)(3)-l(d)(2) (1976).

111 C.f. Federal Pharmacy Services, Inc. v. Comm’r, 72 T.C. 374 (1979). (A nonprofit pharmacy selling drugs at discount or cost to elderly and handicapped persons was held to operate for a substantially commercial and not charitable purpose because of the commercial taint and market competition involved in the enterprise even though the pharmacy clearly provided a service that promoted health.)

112 506 F.2d 1278, 1290 (D.C. Cir. 1974), vacated on other grounds, 426U.S. 26, 46 (1975).

113 Insurance now pays about 90 percent of hospitalization costs and about 60 percent of all physicians’ fees. Demkovich, supra note 30, at 1798.

114 According to the Circuit Court in Eastern Kentucky Welfare Rights Org. v. Simon, “to continue to base the ‘charitable’ status of a hospital strictly on the relief it provides for the poor fails to account for these major changes in the area of health care.” 506 F.2d 1278, 1289 (D.C. Cir. 1974).

115 An organization was granted 501(c)(3) status for promoting health by providing practitioners and nursing care in a manner consistent with the teachings of the Christian Science Church. Rev. Rul. 78-427, 1978-2 C.B. 176. Another received 501(c)(3) status by providing home nursing and theraputic care. Rev. Rul. 72-209, 1972-1 C.B. 148. Others received 501(c)(3) status by providing a rehabilitation program for former mental patients, Rev. Rul. 72-16, 1972-1 C.B. 143; operating a drug rescue service for victims of drug abuse, Rev. Rul. 70-590, 1970-2 C.B. 116; assisting an isolated community lacking medical care to secure such care, Rev. Rul. 73-313, 1973-2 C.B. 174; and facilitating the donation of organs, Rev. Rul. 75-197, 1975-1 C.B. 156.

116 “Lessening of the burdens of Government” is an enumerated charitable purpose in the Income Tax Regulations. Treas. Reg. § 1.501(c)(3)-l(d)(2) (1976).

117 A Congressional report explained:

H. REP. NO. 1860, 75th Cong., 3d Sess. 19 (1939-1 Cum. Bull. (Part 2) 728, 742). See also J.C. Chommie, Federal Income Taxation 703 (2d ed. 1973).

In broad outline, congressional policy in allowing exemption from taxation is based upon the public or nonprofit purpose of the exempt entity while the deduction for contributions to charitable organizations is normally justified on grounds that the recipient organization provides a public service which would otherwise have to be provided by a public agency.

118 There is legislation pending, for example, for national health insurance.

119 42 U.S.C.A. § 1395mm (West 1974 & Supp. 1979) permits HMOs to enroll Medicare recipients. 42 U.S.C.A. § 1396a(23) (West 1974) permits HMOs to enroll Medicaid recipients. Sound Health, for example, had 50 percent Medicaid enrollment. 71 T.C. at 172. HCHP serves approximately 3,000 Medicaid recipients. Interview with Claire McGuire, supra note 50. As of August 30, 1978, HMOs in the United States had 376,422 Medicare enrollees and 229,968 Medicaid enrollees. 1978 Annual Report, supra note 2, at 97.

120 The Commonwealth of Massachusetts HMO Program estimates that HCHP may have saved the state between 10 and 25 percent per Medicaid patient enrolled, because HCHP’s fixed premium was lower than the average fee-for-service costs for Medicaid patients. Interview with Carie Toran, Director HMO Program, Massachusetts Medicaid in Boston, Mass. (April 2, 1980).

121 As of August 30, 1978, 583,445 federal employees were enrolled in HMOs in the United States. 1978 Annual Report, supra note 2, at 97.

122 42 U.S.C.A. § 300e-1(7) (West Cum. Supp. 1974-78) defines “medically underserved populations.“

123 See note 106 supra.

124 See note 16 supra.

125 Treas. Reg. § l.50l(c)(3)-l(d)(ii) (1976).

126 Prohibited inurement of net earnings may be accomplished in a variety of ways. Clearly, earnings inure to an individual through the distribution of dividends. But, even with no direct acquisition or payment of earnings, if a particular individual or limited number of individuals reap commercial benefits from the operation of an organization, this constitutes “inurement” within the meaning of 50l(c)(3). Mertens, The Law of Federal Income Taxation § 34.13, at 63 (1968 ed.).

127 See note 16 supra.

128 Treas. Reg. § l.501 (c)(3)-l(c)(2) (1976). An organization is not operated exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the benefit of private shareholders or individuals.

129 505 F.2d 1068 (6th Cir. 1974).

130 See, e.g., Harding Hospital, Inc. v. United States, 505 F.2d 1068 (6th Cir. 1974). (Section 50l(c)(3) status was denied when it was disclosed that an association of physicians leased hospital facilities at less than fair market value and received direct compensation from the hospital beyond their fee-for-service income); Maynard Hospital, Inc. v. Comm’r, 52 T.C. 1006 (1969) (Section 50l(c)(3) status was denied because hospital profits .were being siphoned off to individual physician-trustees through an arrangement whereby a separate pharmacy operation supplied all the hospital’s pharmaceutical needs at prices well above available commercial rates); Sonora Community Hospital, 46 T.C. 519 (1966), aff’d per curiam, 397 F.2d 814 (9th Cir. 1968) (Section 501(c)(3) status was denied because physicians received a percentage of the profits from the radiology department); Lowry Hospital Ass’n v. Comm’r, 66 T.C. 850 (1976); Kenner v. Comm’r, 20 T.C.M. 185, aff’d, 318 F.2d 632 (7th Cir, 1963) (Section 501(c)(3) status was denied because physicians received unsecured loans and unexplained additional compensation); Fort Scott Clinic & Hospital Corp. v. Brodrick, 99 F. Supp. 515 (1951) (Section 501(c)(3) status was denied because physician salary amounts were fixed by the trustees who were elected by the physicians themselves).

131 Physicians in prepaid group practices earn somewhat less per year than their counterparts in private practice. Luft, supra note 9, at 35. Some HMOs provide special compensation bonuses to reward staff for superior performance and efficient utilization of hospital anl laboratory facilities. These bonuses are related to the HMO’s financial savings and could be viewed as prohibited inurement of benefits to individual employees. These employees bonuses, however, are designed to encourage physicians to be cost conscious; they are not intended to be devices to siphon off assests. Therefore, if bonuses are disclosed and strictly controlled, and if total compensation is reasonable, there is no inurement. See B.H.W. Anesthesia Foundation, Inc. v. Comm’r, 72 T.C. 681 (1979). (The salaries and benefits’ received by members of an anesthesiology department seeking 501(c)(3) status were deemed reasonable and found to be less than what members could earn in private practice.)

132 42 U.S.C.A. § 300e(c)(6)(A) (West Cum. Supp. 1974-78).

133 Id.

134 Sound Health v. Comm’r, 71 T.C. at 171. HCHP’s board does not contain any of its own physicians; one-third are HCHP members and the remaining two-thirds are prominent members of the community. None receives compensation. Interview with Claire McGuire, supra note 50.

135 “Parties in interest” include directors,. officers, employees and major creditors of the HMO. 42 U.S.C.A. § 300e-17 (West Cum. Supp. 1974-78).

136 Treas. Reg. § 1.501(c)(3)-l(d)(l)(ii) (1976).

137 The private benefit prohibition is similar to the inurement prohibition, but is a more general restriction concerning insider dealings. This restriction is imposed by Treas. Reg. § 1.501(c)(3)-l(d)(l)(ii) (1976). According to this regulation, the organization is not tax exempt “unless it serves a public rather than a private interest,” and must not be “organized or operated for the benefit of private interests.” See note 85 supra.

138 71 T.C. at 168.

139 By offering membership to large groups, HMOs save the additional administrative and advertising expenses that would be necessary to enroll individual members.

140 See note 46 supra.

141 Enrollment is often restricted to groups rather than open freely to individuals so that the risk of an individual’s heavy medical cost can be diluted. According to actuarial odds, only a few will require expensive hospitalization. Sullivan, supra note 31, at 47, col. 3.

142 However, HMOs pursuant to the HMO Act are required to provide open or individual enrollment once they reach a sufficient size and financial stability. 42 U.S.C.A. § 300e(d) (West Cum. Supp. 1974-78). See note 6 supra.

143 71 T.C. at 185. The Sound Health court states:

144 Indefiniteness is an essential element of a legal charity. Russel v. Allen, 107 U.S. 163, 167 (1882). Charity begins where certainty in beneficiaries ends. Thomason v. Comm’r, 2 T.C. 441, 443 (1943).

145 71 T.C. at 170. See note 6 supra.

146 E.g. Baltimore Regional Joint Bd. Health & Welfare v. Comm’r, 69 T.C. 554 (1968). See note 95 supra. .

147 This denial also is justified because the employees or union members, in reality, are receiving additional compensation for their labors. Compensation is taxable income.

148 See, e.g., United States v. La Societe Francaise, 152 F.2d 243 (9th Cir. 1945), See note 96 supra.

149 42 U.S.C.A. § 300e(c)(3)(A) (West Cum. Supp. 1974-78).

150 42 U.S.C.A. § 300e(d)(l) & (2) (West Cum. Supp. 1974-78).

151 42 U.S.C.A. § 300e(c)(5) (West 1974). See note 6 supra. :

152 All health insurance plans have this same risk spreading feature, but unlike insurance plans, HMOs are incorporated on a nonprofit basis and actually provide medical care through their own facilities and physicians.

153 See note 106 supra.

154 See notes 103 and 104 supra.

155 1975-2 C.B. 210.

156 46 T.C. 47 (1966).

157 Since membership was restricted to only those property owners who would receive increased value for their property, the private interest was clear. It did not seem equitable that property owners who “contributed” to an organization in order to be able to appreciate their own property should be allowed to deduct these contributions. C.f. Rev. Rul. 78-8S, 1978-1 C.B. 150. (An organization with membership open to the general public was granted 501(c)(3) status when it undertook to beautify a public park); Rev. Rul. 70-186, 1970-1 C.B. 128 (A nonprofit organization was granted 501(c)(3) status when it preserved a lake for public recreation.)

158 I.R.C. § 213(a) provides a medical expense deduction and health insurance deduction from individual taxable income. Thus, premium payments are not contributions, but are deductible under § 213(a) as medical expenses or health insurance.

159 Federal Pharmacy Services, Inc. v. Comm’r, 72 T.C. 374 (1979); Better Business Bureau v. United States, 326 U.S. 279 (1945).

160 125 F.2d 611 (1st Cir. 1942).

161 Id. at 615.

162 71 T.C. at 189.

163 See Rev. Rul. 72-369, 1972-2 C.B. 245. (A consulting firm that otherwise qualified under 501(c)(3) by serving only exempt organizations was found to lack any donative element because consulting is ordinarily for profit and the firm only served as a conduit linking individual researchers with clients.)

164 See Rev. Rul. 68-27, 1968-1 C.B. 315. An organization that issues medical service contracts and direct medical services to various groups and individuals who prepay the contract price at fixed monthly rates is not an insurance company within the meaning of I.R.C. § 801. Even though the organization shifts or assumes risks, this characteristic was deemed to be a normal business consequence’for an organization engaged in furnishing medical services on a fixed-price basis, rather than an insurance risk.

165 The purpose or object for which the income is used is the essential requisite of exempt status. See, Bowan v. Comm’r, 240 F.2d 767, 770 (8th Cir. 1957). In Hassett v. Associated Hosp. Serv. Corp., 125 F.2d 611, 616-18 (1st Cir. 1942), dissenting Judge Magruder argued that there are sound policy reasons why even an organization that just contracts for hospital services should be deemed charitable.

166 Commercial purpose, for example, was found to permeate the Better Business Bureau. Better Business Bureau v. United States, 326 U.S. 279 (1945).

167 Educational institutions, for example, collect tuition before the institution provides educational services, yet educational institutions are still eligible for 501(c)(3) classification.

168 466 F. Supp. 1164 (D.D.C. 1979).

169 Established’pursuant to Title XI of the Social Security Act, 42 U.S.C.A. § 1320c (West 1974 & Cum. Supp. 1975-80).

170 466 F.Supp. at 1170.

171 Rev. Rul. 77-69, 1977-1 C.B. 143.

172 The guidelines were’established and the grants distributed pursuant National Health Planning ahd’Resources Development Act of 1974, 42 U.S.C.A. § (West Cum. Supp: 1974-79).

173 42 U.S.C.A. §§’300e-300e-17 (West 1974 & Cum. Supp. 1974-78).

174 This position was recently argued by Nikki Heidepriem, Special Assistant Secretary, Department of Health,’Education and Welfare, before the IRS.

175 See notes 116-123 supra arid accompanying text for an explanation of how relieve burdens on the’ government. 1320c to the to the HMOs relieve burdens on the government.

176 See notes 49-82 supra and accompanying text, which explain the advantages for HMOs with 501(c)(3) status.

177 See note 120 supra.

178 See, e.g., Bromberg, supra note 68, at 453.

179 See note 58 supra.

180 See I.R.C. § 501.

181 HCHP, for example, has entered into “in lieu of tax” agreements with some local taxing authorities. Interview with Claire McGuire, note 50 supra.

182 See note 174 supra.

183 42 U.S.C.A. §§ 300e - 300e-17 (West 1974 & Cum. Supp. 1974-78).

184 See notes 5 and 6 supra.

185 See notes 103 and 104 supra.

186 See note 120 supra.

187 See note 106 supra.

188 42 U.S.C.A. § 300e(c)(6)(A) (West Cum. Supp. 1974-78).

189 42 U.S.C.A. § 30Oe-17 (West Cum. Supp. 1974-78).

190 42 U.S.C.A. § 300e(c)(3)(A) (West Cum. Supp. 1974-78).

191 42 U.S.C.A. § 300e(d)(l) & (2) (West Cum. Supp. 1974-78) and § 300e(c)(5) (West 1974).

192 Although the organizational, operation and inurement tests of 501(c)(3) are satisfied through federal qualification, the HMO Act places no proscriptions on political activity. In-the unlikely event that an HMO were to operate also as an “action” organization under I.R.C. § 501(h) and Treas. Reg. § 501(c)(3)-l(c)(3) (1976), it would be denied 501(c)(3) status. Since it is unlikely that an organization devoted completely to health care would divert any substantial part of its activities to lobbying or campaigning, it is safe to presume, absent a specific showing to the contrary in an abberational case, that a qualified HMO is not a 501(h) disqualified organization.

193 Sound Health Association, for example, was incorporated as a non-stock, nonprofit corporation under the Washington State Non-Profit Corporation Act. Wash. Rev. Code Ann. § 24.03 (1977).

194 The process of federal qualification may be burdensome because federally qualified HMOs must provide a wide variety of health services and submit reports to the federal government on a regular basis.

195 See note 5 supra. An organization may be denied federal qualification if it fails to provide certain dental treatment or mental health care benefits to its members.

196 Although a few HMOs have been in existence since 1929, most HMOs are more recent.