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On October 28, 2024, the federal appellate court for the Fifth Circuit, in Memorial Hermann Accountable Care Organization v. Commissioner, affirmed a United States Tax Court decision, which held that an Accountable Care Organization in the Medicare Shared Saving Program did not meet its burden of showing that it qualified for exemption from federal income tax under the Internal Revenue Code (Code).  

Section 501(c)(4) Organizations

Memorial Hermann Accountable Care Organization (Memorial) applied for tax-exempt status as an organization described in Code Section 501(c)(4). Section 501(c)(4) organizations are operated exclusively for the promotion of social welfare. While 501(c)(3) charities and 501(c)(4) organizations do not pay federal income taxes, unlike 501(c)(3) charities, donations to Section 501(c)(4)s are not tax deductible.

The Case

The United States Tax Court determined that Memorial did not quality for exemption because it primarily benefited health care providers and insurance companies.  

In doing so, the Tax Court applied a test established by the United States Supreme Court, known as the “substantial non-exempt purpose” test, which states that the presence of a single substantial nonexempt purpose will preclude exempt status, regardless of the number or importance of exempt purposes.  

On appeal, Memorial asserted that it was not formed to earn a profit, but to support public welfare. Memorial also argued that, instead of applying the substantial non-exempt purpose test, the Tax Court should have applied the “primary purpose test” set forth in Treasury Regulations which provide as long as an organization is primarily engaged in an exempt activity, the organization will qualify as tax-exempt.  

On appeal, the federal appellate court determined that the Tax Court properly employed the substantial non-exempt purpose test, and that Memorial engaged in more than an insubstantial amount of tax-exempt activities, thus precluding Memorial from qualifying for tax-exemption.

Observations

A few observations can be made from the federal appellate court’s decision in Memorial.  First, although the Fifth Circuit rejected Memorial’s argument that the primary purpose test should have been used, the Fifth Circuit in a footnote stated that it would have reached the same conclusion by applying either test. 
 
Second, it is interesting that, while the federal appellate court in its decision cited the recent U.S. Supreme Court decision in Loper Bright Enterprises v. Raimondo, which allowed the court not to defer to Treasury Regulations, the court, nevertheless, handed the Internal Revenue Service a victory.  

Finally, because Memorial is a Fifth Circuit decision, the opinion is currently binding for organizations located only in Louisiana, Mississippi and Texas. Nevertheless, since it is reasonable to conclude that there is nothing particularly special about Accountable Care Organizations that should insulate them from paying federal income taxes, one would expect a similar result would be reached elsewhere in the United States.

Douglas T. Coats
410-576-4002 • dcoats@gfrlaw.com