IRS toughens its guidelines on tax exemption for HMOs

Healthcare Financial Management, Jan, 1991 by Phillip G. Royalty

Operating in a manner similar to for-profit insurers or Blue Cross and Blue Shield indicates commercial type insurance. But the distinction between a staff model and a non-staff model HMO does not alone determine whether an HMO is providing commercial type insurance, according to the IRS.

The IRS does not see the legislative history of section 501(m) as indicating that HMOs never will be recognized as providing commercial type insurance within the meaning of the section. Instead, whether an HMO is providing section 501(m) commercial type insurance will be based on the facts and circumstances involved-not solely on whether an HMO operates on a staff, group, network, or IPA model. If the insurance aspects of an HMO are minor, it will not be found to be providing commercial type insurance.

Unless unusual circumstances exist, an HMO operating one of the common, existing" models that compensates primary care physicians exclusively on a salary, capitation, or another fixed-fee basis will not be barred from exemption under section 501(m), even though the HMO may pay other providers on a fee-for-service basis.

"Common, existing" HMOs refers to the way they were commonly structured and operating at the time of the Tax Reform Act of 1986. The IRS maintained that many new hybrid organizations being developed, while formerly called HMOs, closely resemble indemnity insurers in operation, such as point of service plans or open-ended HMOs. They will be excluded from tax-exempt status if a substantial part of their activities consists of providing out-of-plan benefits on a true indemnity basis. If the activities are insubstantial, they will be treated as unrelated business.

The IRS lists the following factors in determining whether commercial type insurance is being provided:

  * Whether an insurance risk is being
  transferred and distributed;
  * Whether and to what extent an
  organization is operating similar
  to for-profit insurers or Blue
  Cross and Blue Shield;
  * Whether and to what extent an
  organization is marketing a product
  similar to for-profit insurers
  or Blue Cross and Blue Shield;
  * Whether and to what extent an
  organization directly provides
  healthcare services; and
  Whether and to what extent an
  organization has shifted any risk
  or loss to service providers
  through salary or fixed-fee compensation
  arrangements.
  In determining whether an
HMO's insurance activities are "incidental"
within the meaning of
section 501(m)(3)(B), the IRS added
in GCM 39829, it must be satisfied
that any insurance element is a necessary
and normal consequence of
the HMO's principal activity.
  Insurance risk undertaken by
staff model and other fixed expense
HMOs (such as for care outside an
HMO's service area or outside its
capabilities), provided it is an insubstantial
part of the HMO's operations,
is excluded from the definition
of commercial type insurance
under section 501(m), according to
GCM 39828.
  Based on these factors, the memo
concluded that Plan A provided
commercial type insurance under
section 501(m) but that Plan B did
not because its method of operation
effectively transferred the  vast majority"
of the insurance-type risk it
assumed from its subscribers to its
service providers.
  In addition, GCM 39829 concluded
that the IPA-model HMO
described in the memo retained its
tax exemption after the effective
date of section 501(m). The HMO
was Federally qualified and paid for
physician services on a capitated
basis. The payments represented
approximately half of the total cost
of medical services provided, and
other payments were not capitated.
  GCM 39829 also made the following
observations about the applicability
of section 501(m) to HMOs:
  * The term "insurance company"
  under tax rules pertaining to taxable
  insurance companies is not
  the same as "commercial type insurance"
  under section 501(m).
  * This suggests the IRS may not
  agree that an HMO barred by the
  section from exempt status necessarily
  qualifies as an insurance
  company for tax purposes;
  * The fact that an HMO employs its
  own staff and operates its own
  facilities or otherwise fixes its
  costs by shifting a substantial
  portion of the risk to providers
  may be the only practical way to
  distinguish it from commercial
  insurers or Blue Cross and Blue
  Shield;
  * Non-staff, non-group practice
HMOs that pay providers on a
fee-for-service basis, even when
subject to a percentage withhold
or reduction for over-utilization,
are much harder to distinguish
from commercial insurance companies
and Blue Cross and Blue
Shield. No opinion was expressed
about whether these
HMOs primarily provide services
or an insurance-type benefit-or
whether they fit within the section
501(m)(3)(B) exception;
  * Without unusual facts, an HMO
operating on one of the common
existing models that compensates
primary care physicians exclusively
on a salary, capitation, or
other fixed-fee basis principally
provides health care and only incidental
health insurance, even
though the HMO pays other providers
on a fee-for- service basis.
Unusual facts would include
cases in which providing or arranging
for primary care is an
insignificant part of an HMO's activities
or the HMO does not use
a gatekeeper approach; and
  * Salary and captation agreements
with primary physicians (compared
to agreements with specialists
and hospitals) ordinarily
should be given greater weight in
determining whether an HMO's
insurance aspects are incidental.
HMOs with an IRS exemption
letter or those about to apply for
one should consider the effect of
the guidelines on their tax-exempt
status. Those adversely affected
may want to reorganize to preserve
their exemptions.