Three Things To Know About Joint Operating Agreement Transactions

June 26, 2013

The nonprofit healthcare industry in the United States is in the midst of significant change. A variety of different operational arrangements are being devised to achieve efficiencies and improve particular institutions’ financial health, including joint operating agreements (JOAs). Unlike absolute financial and structural control affiliations, where a centralized authority has power over participating hospitals’ boards of directors and assets, the purpose of a JOA is to protect a business from failure, yet prevent monopolization within an industry by allowing each party to retain some form of separate operation. JOAs became popular in the mid-1990s when the Internal Revenue Service (IRS) issued several favorable private letter rulings involving JOAs. Many JOA transactions were undertaken, some completed and others ended with buyouts of one of the participants by the other. JOA transactions then started to decline in the late 1990s and early 2000s; however, today with the increase of mergers and acquisitions in the healthcare industry, JOA arrangements are again attracting attention. Here are three key characteristics parties should consider before aligning under a JOA:

1. Structural Characteristics: Because a JOA affiliation is not a true merger, it has come to be called a “virtual merger,” and is implemented by contract rather than by transfer of assets. A JOA is typically accomplished by forming a new corporation, known as a Joint Operating Company (JOC), which is formed to serve as the parent to two or more affiliating hospitals. The JOC is created with the expectation that it will qualify as a Section 501(c)(3) organization and will enter into JOAs with the participating hospitals.

The hallmark of JOA affiliations is that the hospital parties retain their separate identities and boards of directors, as well as a certain amount of autonomy, even though considerable management and financial authority is shifted to the JOC. The JOA itself will outline the intended legal relationship between the parties; will address various governance, management and financial issues; and will contain termination provisions. Additionally, the JOA will set forth representations, warranties and covenants similar to those found in traditional merger documents.

2. Tax Exemption: The JOA/JOC structure brings into play several tax issues that affect not only the JOC itself, but also the hospital parties that affiliate with the JOC through JOAs. The principal issue arising in a JOA/JOC structure is whether the equivalent of a parent/subsidiary relationship has been established to allow payments from one hospital to another to be exempt from taxation as unrelated trade or business income. When a tax-exempt hospital provides support activities to exempt hospitals for a fee, it is usually subject to unrelated business income tax pursuant to IRC 511. However, if the equivalent of a parent-subsidiary relationship is established, dealings between the parent and the subsidiary that would otherwise have resulted in unrelated trade or business activity are considered to be merely a matter of accounting rather than unrelated trade or business activity under IRC 513.

Typically a JOA/JOC structure does not fall under a “traditional” parent/subsidiary corporate structure, and therefore tax-exempt hospitals may be reluctant to enter into a JOA/JOC transaction in which they are subject to the control of a taxable organization. To determine if a parent/subsidiary relationship has been established, the IRS utilizes a “facts and circumstances” approach to ensure that the JOC has, under the terms of the JOA, been granted significant control over management, operational and financial decisions affecting the affiliated hospitals, such that the JOC is viewed as the equivalent of a parent corporation. To evaluate whether sufficient “control” exists in the JOA/JOC structure, the IRS looks to numerous factors, including:

  1. Which entity is authorized to determine whether to establish, consolidate or eliminate services, and which entity has authority to allocate services between the facilities.
  2. Whether the JOC board exercises day-to-day and long-range management authority over the participating hospitals.
  3. Whether the JOC has power to initiate an action against participants, rather than just mere veto power.
  4. Who approves capital transactions.

Ultimately, the IRS will evaluate the facts and circumstances of the JOA/JOC structure to ensure that sufficient control is vested in the JOC, both functionally and financially, to establish its treatment as a parent corporation of the affiliated hospitals.

3. Antitrust Issues: JOA/JOC structures also ignite antitrust concerns because they involve the collaboration by two or more hospitals, often competitors, in carrying out the activities that each hospital might have carried out separately. Although the JOA/JOC structure results in the sharing of risks, economies of scale or efficiencies of integration, the arrangement typically is allowed under antitrust law if the following criteria are met:

  1. The scope of the JOA/JOC structure in terms of functions, geography and time is limited to that which is reasonably required to achieve the benefits that justify the joint operation.
  2. The JOA/JOC structure avoids “spill over” from the joint operation to other activities in which the hospital parties remain competitors.
  3. The JOA/JOC structure does not impose unreasonable ancillary restraints on the hospital parties.

In all, a JOA/JOC structure may be an attractive alternative to a traditional merger for tax-exempt hospitals and health systems. For more information about forming a JOA, please contact one of the authors.