Coordinated Issue Paper - Blue Cross Blue Shield/Health Insurance; Life Insurance (Effective Date: June 4, 2008)
Effective Date: June 4, 2008
Conversion of Nonprofit Organizations
This issue paper is not an official pronouncement of the law or the position of the Service and cannot be used, cited or relied upon as such.
This issue paper discusses the conversion of Blue Cross Blue Shield (BCBS)organizations, but the position described may apply to any taxable nonprofit organization that converts to for-profit status.
General Issue: Where a Nonprofit or Public Benefit Organization Makes a Payment or Transfer for Value in Satisfaction of a Charitable Trust Obligation, No Deduction is Allowed with Respect to the Payment or Transfer or for Related Fees or Expenses.
Primary Position: No Deduction for Trustee Transfer.
A payment or transfer in satisfaction of a charitable trust obligation is a nonrecognizable transaction. The transferor as trustee has no taxable interest in assets that are charged with a charitable trust, and does not engage in a recognizable transaction when it transfers the trust assets to a successor trustee.
Alternative Position: No Deduction for Capital Expenditure.
In the alternative, to the extent the transaction is recognizable, it should be considered a capital expenditure connected with the restructuring or reorganization of the taxpayer from a nonprofit to a for-profit entity and not an ordinary and necessary business expense.
Alternative Position: No Deduction for Expenses Allocable to Tax Exempt Income.
In the alternative, under certain circumstances to the extent a payment or transfer is associated with the taxpayer's nonprofit activities or nonprofit status during a period in which it was exempt from federal income tax, any deduction would be barred by I.R.C. § 265.
Stock Transfers: Where a Nonprofit or Public Benefit Organization Transfers Stock in Satisfaction of a Charitable Trust Obligation, No Deduction is Allowed with Respect to the Transfer or for Related Fees or Expenses.
In some cases, a nonprofit or public benefit organization transfers stock in satisfaction of a charitable trust obligation. Whether the charitable trust obligation is satisfied by a payment in cash or by a transfer of other property or stock, no deduction is allowed under the three legal theories described above.
Conversion Followed by Merger or Acquisition: Where a Nonprofit or Public Benefit Organization Makes a Payment or Transfer for Value in Satisfaction of a Charitable Trust Obligation, No Deduction is Allowed at the Time of a Subsequent Merger or Acquisition.
In some cases, a nonprofit or public benefit organization makes a payment or transfer for value in satisfaction of a charitable trust obligation, and later merges with or is acquired by a for-profit organization. Under a capitalization theory, taxpayers have argued that any amount capitalized should be allowed as a deduction at the time of the later transaction. Consistent with the Service's primary position stated above, the initial transfer is considered a nonrecognizable transaction and no deduction is allowable, either at the time of the initial transfer, or at the time of any later transaction. Furthermore, even if the initial transfer is recognized and is considered a capital expenditure, there is no loss of value and no deduction is allowed at the time of the later transaction.
Initial Structure and Organization of BCBS Plans
Blue Cross plans and Blue Shield plans developed separately along similar lines, with Blue Cross plans providing coverage for hospital services, while Blue Shield covered physicians' services. In general, the plans were organized on a state-by-state basis, under special legislation requiring that the plan operate on a nonprofit basis and declaring it a "charitable and benevolent institution."
The Blue Cross and Blue Shield names and symbols are controlled by the Blue Cross Blue Shield Association in Chicago. Prior to June 1994, the Association's membership standards and licensing agreements required that its member licensees be nonprofit organizations.
The Tax Reform Act (TRA) of 1986
Prior to 1986, the Service determined that prepaid hospitalization plans did not qualify for exemption as "charitable organizations" within the meaning of the predecessor of I.R.C. § 501(c)(3), but could be considered "social welfare organizations" within the meaning of the predecessor of section 501(c)(4).
In 1985, Congress considered modifying the tax treatment of BCBS organizations. While a House bill was pending, the General Accounting Office did a study comparing BCBS plans with commercial insurers, with emphasis on the provision of health insurance to high-risk individuals. The BCBS Association reviewed the draft report and argued that its members' exemption from tax was warranted for several reasons. The Association asserted that "The plans are nonprofit community service organizations that finance health care for individuals and small groups who could not obtain health insurance elsewhere" (emphasis added). General Accounting Office, "Health Insurance, Comparing Blue Cross and Blue Shield Plans With Commercial Insurers," GAO/HRD-86-110, at 9 (July 1986).
Ultimately, TRA '86 added a new I.R.C. § 501(m) which effectively revoked the tax exemption of BCBS organizations by denying exemption to organizations with substantial activities providing commercial-type insurance. The Act also added I.R.C. § 833 providing that BCBS organizations shall be taxable in the same manner as stock insurance companies, but with certain modifications and special benefits.
The Charitable Trust Doctrine
In the 1990's, some nonprofit organizations began to convert to for-profit stock companies. Since the BCBS Association required that its member organizations be operated on a nonprofit basis, some BCBS plans attempted to obtain the benefits of a conversion by organizing for-profit subsidiaries while the parent organization maintained its nonprofit status. In June 1994, the BCBS Association changed its rules to allow its licensees to be for-profit organizations.
The Restatement (Second) of Trusts § 348 defines a charitable trust as “a fiduciary relationship with respect to property arising as a result of a manifestation of an intention to create it, and subjecting the person by whom the property is held to equitable duties to deal with the property for a charitable purpose.” See also Austin Wakeman Scott and William Franklin Fratcher, The Law of Trusts, § 348 (4th ed. 1989 & 2004 Supp.) (“Scott on Trusts”). The principles that apply to charitable trusts ordinarily apply to charitable corporations, including nonprofit corporations engaged in the promotion of health. Restatement (Second) of Trusts, §§ 348 and 372; Scott on Trusts, §§ 348.1 and 372. State attorneys general are responsible for overseeing that the fiduciary duties of a charitable trust are being upheld. Restatement (Second) of Trusts, §§ 348 and 391; Scott on Trusts, §§ 348.1 and 391.
If a charitable organization enters into a conversion transaction, an attorney general may assert the charitable trust doctrine and require the organization to transfer the assets accumulated during its charitable status to serve the same or similar charitable purposes. See Restatement (Second) of Trusts, §§ 392 and 399; Scott on Trusts, §§ 392 and 399; Tauber v. Commonwealth of Virginia, 255 Va. 445, 455, 499 S.E. 2d 842 (1998); Queen of Angels Hospital v. Younger, 66 Cal. App. 3d 359, 365-66 (1977). When an organization transfers assets to satisfy a charitable trust obligation, the organization is carrying out its equitable duty as a fiduciary to use the assets for a charitable purpose. The assets that are transferred are not equitably owned by the organization, but instead are held in trust for a charitable purpose.
Elements of Conversion Transactions
These cases present a variety of fact patterns, in part because prior to June 1994 BCBS organizations devised transactions that were intended to achieve the effect of a conversion while maintaining the appearance of a nonprofit; recognition of the conversion and enforcement of the charitable trust obligation often did not occur until long after the transaction had been completed; and BCBS organizations resisted any acknowledgment of that obligation. In early cases where the transaction was completed before any charitable trust obligation was acknowledged or enforced, the cases were generally resolved by some later cash payment. After June 1994, it is more common to see direct conversions, with the charitable trust obligation taken into account in the regulatory review and approval of the conversion transaction. In some cases, the BCBS organization argued that the conversion had effectively occurred at an earlier date when a change was made in its status under state law. Under those circumstances, the amount of the charitable trust obligation may be measured at the earlier date, reducing the amount of the payment that is made. More recently, states have enacted legislation governing conversion transactions which require the converting organization to transfer stock to a charitable foundation.
The Federal Income Tax Issue
Although these cases may have been controversial at the state level and generated a variety of fact patterns, for federal income tax purposes the relevant facts are relatively simple: the tax issue in these cases arises because the taxpayer claimed a deduction; the deduction is based upon a payment or transfer for value; the payment or transfer was made in satisfaction of a claim; and the claim is founded on the charitable trust doctrine. In other words, there is no federal income tax issue unless the BCBS organization makes some payment or transfer for which it claims a federal income tax deduction, but in every case the purpose for that payment or transfer is the satisfaction of some claim that the BCBS organization has or will be converting from nonprofit to for-profit status, triggering a charitable trust obligation.
A number of arguments may be raised in these cases depending on the particular fact pattern. The common element in all the cases is the assertion that the BCBS organization has or will be converting from nonprofit to for-profit status, and a payment or transfer for value by the BCBS organization to resolve that claim. The arguments fall into three broad categories. The Government's primary position is the trustee transfer argument. The Government's principal alternative argument is the capital expenditure argument, with several subarguments. Under certain specific circumstances the Government may make a second alternative argument, the tax exempt income argument.
1. No Deduction for a Transfer to a Successor Trustee.
For federal income tax purposes, the significance of the charitable trust doctrine is that the organization’s assets were not owned by the organization -- they were being held in trust for the benefit of the persons the charitable organization was formed to serve. When an organization transfers assets or makes a payment in satisfaction of the charitable trust obligation, it is carrying out its equitable duty as a fiduciary to continue using the assets for a charitable purpose. Because these assets were not owned by the organization, it is not entitled to a deduction upon making a payment that represents the value of the assets.
The payment is similar to a transfer of trust assets to a successor trustee. See e.g., Scott on Trusts §§ 397.3, 399. LaDow v. Commissioner, 3 B.T.A. 219 (1925) (stock held in trust); Los Angeles Cemetery Association v. Commissioner, 2 B.T.A. 495 (1925) (perpetual care fund); American Cemetery Co. v. United States, 28 F.2d 918, 919 (D. Kan. 1928) (permanent maintenance fund); Memphis Memorial Park, Inc. v. Commissioner, T.C. Mem. 1959-147 (permanent improvement fund); Metairie Cemetery Association v. United States, 282 F.2d 225 (5th Cir. 1960) (perpetual care fund).
2. No Deduction for a Capital Expenditure.
In the alternative, to the extent the transaction is recognizable, it should be considered a capital expenditure connected with the restructuring or reorganization of the taxpayer from a nonprofit to a for-profit entity and not an ordinary and necessary business expense. This argument assumes the taxpayer does have an interest in the assets, but the deduction is disallowed because the conversion payment is considered a capital expenditure. Woodward v. Commissioner, 397 U.S. 572 (1970); United States v. Hilton Hotels Corp., 397 U.S. 580 (1970). The conversion payment would be a payment made to facilitate a restructuring pursuant to Treas. Reg. § 1.263(a)-5(a)(4)(applicable to any payment made after December 31, 2003).
In support of the deduction of conversion payments, BCBS organizations have relied upon the "origin of the claim doctrine," arguing that the payments arise not from a conversion, but from their prior status as nonprofit organizations. Much of their argument deals with cases and rulings involving items of a common and recurring nature, such as legal expenses, and whether under particular circumstances those items should be considered capital expenditures because they arise in a capital transaction.
However, conversion payments are not some incidental item that occurs on the periphery of the transaction. These payments are the essence of the transaction, and the transaction defines the payments. The conversion of a nonprofit organization to for-profit status is not the equivalent of a change in name or change in the jurisdiction of incorporation. A conversion fundamentally changes the nature of the organization. It is no longer defined by its charitable purpose; it no longer has a charitable obligation. From the date of conversion forward, it is a different organization, with a different purpose and different obligations. In order to convert from nonprofit to for-profit status, the charitable trust doctrine requires that the converting organization pay over its accumulated assets for charitable purposes. No payment would be required unless a conversion occurred; no conversion would be allowed unless a payment is made.
Main general argument. The conversion of a nonprofit organization to for-profit status is in the nature of a restructuring, reorganization, or recapitalization, which are commonly considered capital transactions. Accordingly, a payment made as part of a conversion should be considered a capital expenditure.
a. Conversion pursuant to specific legislation. In some cases the conversion transaction is carried out under specific state legislation which requires the payment as a condition for the conversion. The taxpayer has invoked the statute as authority for the transaction, and makes the required payment. Under those circumstances, it is clear that a conversion has occurred, and that the payment was made as a condition for the conversion. This is probably the strongest fact pattern for arguing that the payment is a cost of restructuring.
b. Indirect conversions. In some circumstances, a transaction may not be structured as a direct conversion, and no payment for charitable purposes may be made or acknowledged at the time of the transaction. The transaction may even have been approved by state regulators with no requirement for a payment. At some later date the state may assert that a conversion occurred and that a payment should have been made. Under those circumstances, an additional argument can be made that the payment in settling the dispute should be considered a cost of defending title. Treas. Reg. § 1.263(a)-2(c). Murphy Oil Co. v. Commissioner, 15 B.T.A. 1195, 1201 (1929), nonacq., 1930-1 C.B. 71, aff’d on other grounds, 55 F.2d 17 (9th Cir. 1932), aff’d, 287 U.S. 299 (1933).
c. Sales. A nonprofit organization may transfer all or a substantial portion of its assets to an unrelated for-profit entity. As with an indirect conversion, the sale may be approved by regulators with no requirement of any payment for charitable purposes. As with an indirect conversion, the state may later assert that a conversion occurred and that a payment is due. Under those circumstances, any payment made in settling the dispute should be considered part of the purchase price. Treas. Reg. § 1.263(a)-(2)(a).
3. No Deduction for Expenses Allocable to Tax Exempt Income.
The trustee transfer argument and the capitalization argument are alternative arguments that rely on different legal theories. The trustee transfer argument assumes the taxpayer does not have an interest in the assets that are being transferred, while the capitalization argument assumes the taxpayer does have an interest in the assets. Both arguments could be made in the same case, although variations of the capitalization argument may be made depending on the particular fact pattern of the case.
In some cases, BCBS organizations have attempted to separate the payment from the conversion transaction by arguing that the "origin of the claim" is the taxpayer's prior status as a nonprofit organization. This argument assumes the taxpayer has an interest in the assets, but it does not really address whether the payment is ordinary or capital; it merely dissociates the payment from the actual conversion transaction. However, if it is determined that the amount paid is an ordinary and necessary expense, it does not follow that it is deductible. The only justification for treating such a payment as an "ordinary" expense is the taxpayer's assertion that it relates to the taxpayer's status as a tax-exempt corporation. If so, then the expense is not deductible under the clear prohibition of I.R.C. § 265, which disallows any deduction for "[a]ny amount otherwise allowable as a deduction which is allocable to one or more classes of income . . . wholly exempt from the taxes imposed by this subtitle.” Anclote Psychiatric Center, Inc. v. Commissioner, T.C. Mem. 1998-273; Stroud v. United States, 906 F.Supp. 990 (D. S.C. 1995); Rickard v. Commissioner, 88 T.C. 188 (1987); Fabens v. Commissioner, 62 T.C. 775 (1974), aff’d in part and rev’d in part, 519 F.2d 1310 (1st Cir. 1975).
The tax-exempt income argument is similar to the capitalization argument since it assumes that the taxpayer does have an interest in the assets. Unlike the capitalization argument, the tax-exempt income argument also assumes that the transfer of the assets is a deductible expense. However, the tax-exempt income argument does not apply in all case, but generally applies in cases where the taxpayer contends that the conversion occurred prior to January 1, 1987, when BCBS organizations were still tax-exempt for federal purposes. In many cases where the state attorney general has sought to enforce the charitable trust obligation, the BCBS organization first contends that it has never been a charitable trust, or that if it was, it lost that status at some earlier date, generally associated with the loss or reduction of its state tax exemption. Further, the BCBS organization argues that its charitable trust obligation should be measured by its accumulated surplus at that earlier date, rather than the net fair market value of its assets. The BCBS organization is thus able to reduce the amount of its conversion payment by moving the effective date of the conversion back to an earlier period when it had less accumulated surplus, and by measuring its charitable trust obligation by the amount of its accumulated surplus, which is generally less than the net fair market value of its assets.
The tax-exempt income argument may also apply in cases where the conversion payment is measured at some date after January 1, 1987, to the extent it can be shown that the accumulated surplus arose prior to January 1, 1987. Many BCBS organizations reported net operating losses for their first few years after December 31, 1986. Thus, during that period whatever accumulated surplus they showed was derived from tax exempt income.
4. No Deduction for Fees and Expenses.
The “origin of the claim” doctrine arose as a test to determine the deductibility of litigation expenses. United States v. Gilmore, 372 U.S. 39 (1963); United States v. Patrick, 372 U.S. 53 (1963). Broadly speaking, legal expenses share the characterization of the underlying claim and are considered personal, capital, or ordinary and necessary depending on the nature of the underlying claim.
Under certain circumstances, as for example where litigation involves multiple claims, the characterization of some portion of the legal expenses may differ from the characterization of the principal claim. Even though the principal claim may involve a nondeductible personal or capital transaction, some portion of the legal expenses may be considered deductible to the extent that the defense of the claim to which they are allocable is considered an ordinary and necessary activity. See, e.g., Dolese v. United States, 605 F.2d 1146 (10th Cir. 1979).
The fact that some portion of the legal fees incurred in a multi-claim lawsuit may be deductible does not establish that the payment of the principal claim involved in the suit is deductible. Care must be exercised in analyzing such legal authorities to be sure that the "claim" which supports a deduction is actually analogous to the claim in the case under examination.
Based upon the legal theories described above which bar deduction for conversion payments, no deduction is allowable for the fees and expenses of the conversion transaction.
5. No Deduction for the Fair Market Value of Stock Transferred in a Conversion Transaction.
In some cases, a nonprofit or public benefit organization transfers stock in satisfaction of a charitable trust obligation and claims a deduction for the fair market value of the stock. Whether the charitable trust obligation is satisfied by a payment in cash or by a transfer of other property or stock, no deduction is allowed under the three legal theories described above.
6. Where No Deduction is Claimed or Allowed at the Time of a Conversion Payment, no Deduction is Allowed at the Time of a Subsequent Merger or Acquisition.
Under a capitalization theory, a taxpayer may claim a loss for the amount of a conversion payment when the for-profit entity later merges with or is acquired by some other organization. As explained above, the trustee transfer argument and the capitalization argument are alternative arguments that rely on different legal theories. Capitalization is not allowed as an alternative to the trustee transfer argument; rather, capitalization provides an additional argument for disallowing a current deduction.
The Service's primary position under the trustee transfer theory is that the initial payment or transfer in satisfaction of the taxpayer’s charitable trust obligation is a nonrecognizable transaction. No deduction is allowable, and there is no amount that may be capitalized. Accordingly, no amount is deductible at the time of any later transaction.
Furthermore, even if the initial transfer is recognized and is considered a capital expenditure, there is no loss of value at the time of the later transaction. Public reports of BCBS conversions, mergers, and acquisitions show situations where an acquisition took place with no conversion payment, followed by some enforcement action and a later payment. In other cases, conversion payments were made as part of the acquisition or merger transaction. Finally, in some cases a conversion payment was made and later the converted entity merged or was acquired with no further payment being made. Comparison of these three situations demonstrates that the conversion payments have continuing value.
Issues That Should Not be in Dispute
Some taxpayers confuse the federal income tax issue by raising arguments that are no longer relevant to the issue in dispute: they argue that they are not charitable trusts under state law; that they are not "charities" under the Internal Revenue Code; and that no conversion has occurred. These arguments may have had some relevance at the state level when the taxpayer was contesting the validity of the attorney general’s claim, but they are no longer relevant to the federal income tax issue. For federal income tax purposes, the characterization of the payment or transfer depends upon the origin of the claim, not the validity of the claim. Seay v. Commissioner, 58 T.C. 32 (1972); Bent v. Commissioner, 87 T.C. 236 (1986), aff'd, 835 F.2d 67 (3rd Cir. 1987).
“Taxpayer Not a Charitable Trust.”
Accordingly, the fact that the taxpayer continues to deny that it is or was a charitable trust under state law is not relevant to the federal income tax issue. For federal income tax purposes, the relevant fact is that the state attorney general asserted a claim that the taxpayer’s assets were subject to a charitable trust, and that the taxpayer made a payment or transfer to resolve that claim. Furthermore, while the validity of the state attorney general’s claim is not an issue for federal income tax purposes, a taxpayer’s continuing assertion that it is not or never was a charitable trust under state law is generally inconsistent with the special legislation under which BCBS plans were organized, which required that the plan operate on a nonprofit basis and declared that it was a “charitable and benevolent institution.” Such assertions are also inconsistent with the background of TRA ’86, when the BCBS Association represented to the GAO that all of its member plans were nonprofit community service organizations.
“Taxpayer Not a Charity.”
Whether a taxpayer qualifies as a "charitable organization" for federal income tax purposes is doubly irrelevant at this point: first, because the validity of the state attorney general’s claim is not the issue for federal income tax purposes, and second, because the taxpayer’s status for federal income tax purposes is not conclusive in determining whether it is subject to the charitable trust doctrine under state law. State attorneys general have routinely applied the charitable trust doctrine to "charitable and benevolent" organizations under state law without regard to whether they would be considered "charitable organizations" for federal income tax purposes. In addition, as indicated above, for federal income tax purposes the significance of the charitable trust doctrine is not that the taxpayer is being characterized as a “charity” for purposes of state law, but that its assets are considered to be held in trust.
“Payment is Not for Conversion.”
Finally, for federal income tax purposes it is not necessary to determine whether a conversion did in fact occur. For federal income tax purposes the relevant fact is that the payment or transfer was made in satisfaction of an alleged charitable trust obligation. In most cases the state attorney general's complaint may allege a number of different claims, but however they are described, the common element derives from the attorney general's characterization of the taxpayer as a charitable trust. Typically the taxpayer denies the alleged claims. In addition, where there is a written settlement agreement, it is not uncommon for it to include a denial of liability by the taxpayer. At the same time, however, the agreement will include clauses in which the taxpayer is released and discharged of any charitable trust obligation. In addition, in most cases the payment or transfer is made to an organization which is recognized as a charitable organization for tax purposes. The fact that the taxpayer receives a release from its charitable trust obligation, and the fact that the payment or transfer is made to some successor charitable organization establish that the claim that is being satisfied by the transfer or payment is the charitable trust claim.
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