Court Opinion

ID: 4332331
Source: CourtListenerOpinion
Date Created: 2018-11-14 00:39:11.060742+00
Date Added: 2024-06-11T14:47:53.682860
License: Public Domain

113 T.C. No. 3

                    UNITED STATES TAX COURT

           REDLANDS SURGICAL SERVICES, Petitioner v.
         COMMISSIONER OF INTERNAL REVENUE, Respondent

   Docket No. 11025-97X.                 Filed July 19, 1999.

        P is a nonprofit corporation. Its sole activity
   is participating as co-general partner with a for-
   profit corporation in a partnership that is general
   partner of an operating partnership that owns and
   operates an ambulatory surgery center. Held: On the
   facts involved herein, P has ceded effective control
   over the operations of the partnerships and the surgery
   center to private parties, conferring impermissible
   private benefit. P is therefore not operated
   exclusively for exempt purposes within the meaning of
   sec. 501(c)(3), I.R.C. 1986.

    James L. Malone III and Robert C. Louthian III, for

petitioner.

    Joan Ronder Domike and Elizabeth Purcell, for respondent.
                                - 2 -

     THORNTON, Judge:    Petitioner brought this action for a

declaratory judgment, pursuant to section 7428 and Title XXI of

this Court's Rules.    Petitioner requests the Court determine the

correctness of respondent’s adverse determination with respect to

its initial qualification as a tax-exempt organization under

section 501(c)(3).1   The parties have submitted this case fully

stipulated under Rule 122 on the basis of the pleadings and the

stipulated administrative record, which is incorporated herein by

this reference.

                          FINDINGS OF FACT

     Petitioner is a California nonprofit public benefit

corporation with its principal place of business in Redlands,

California.   It is a wholly owned subsidiary of Redlands Health

Systems, Inc. (RHS), a California nonprofit public benefit

corporation that has been recognized as exempt under section

501(c)(3) of the Code and as a public charity within the meaning

of section 509(a).    RHS is the parent corporation of three

subsidiaries in addition to petitioner, namely Redlands Community

Hospital (Redlands Hospital) and Redlands Community Hospital

Foundation (Redlands Foundation), both of which are California

nonprofit public benefit corporations that have been recognized

     1
       Unless otherwise indicated, all section references are to
the Internal Revenue Code as in effect for the time period
referred to. All Rule references are to the Tax Court Rules of
Practice and Procedure.
                               - 3 -

as exempt under section 501(c)(3); and Redlands Health Services,

a for-profit corporation.

      As described in more detail below, and as reflected

schematically in the appendix hereto, in 1990 RHS became co-

general partner with a for-profit corporation, Redlands-SCA

Surgery Centers, Inc. (SCA Centers), in a general partnership

formed to acquire a 61-percent interest in an existing outpatient

surgical center in Redlands, California, two blocks from the

Redlands Hospital facility.   This general partnership in turn

became sole general partner in the California limited partnership

that owns and operates the surgical center.   Under a long-term

management contract, SCA Management Co. (SCA Management)--a for-

profit affiliate of SCA Centers--manages the day-to-day

operations of the surgical center, in return for a percentage of

gross revenues.   Several months after forming the general

partnership, RHS formed petitioner to succeed to its interest in

it.

      Petitioner has no activity other than its involvement with

the partnerships.   The question is whether petitioner is operated

exclusively for exempt purposes within the meaning of section

501(c)(3).   We hold that it is not.

Redlands Hospital

       Since its founding in 1929, Redlands Hospital has been

recognized by respondent as a charitable organization described
                                - 4 -

in section 501(c)(3) and as a "hospital" described in section

170(b)(1)(A)(iii).    Its mission includes providing necessary

medical care free of charge, or at a discount, to individuals

without insurance or other means of paying.

     Redlands Hospital has its own outpatient surgery program

within the hospital facility.    It also maintains a 24-hour

emergency room that provides emergency medical services for all

patients regardless of their ability to pay.    It maintains an

open medical staff and is governed by a community-based board of

directors.    It does not discriminate on the basis of race,

gender, age, color, national origin, or disability.

Inland Surgery Center, L.P.

     Since its inception in 1983, the Inland Surgery Center

Limited Partnership (the Operating Partnership) has operated a

freestanding ambulatory surgery center (the Surgery Center) in a

12,000-square foot building within two blocks of Redlands

Hospital.    During the 1980's, the Operating Partnership was a

successful for-profit venture, serving only surgical patients who

were able to pay, by insurance or otherwise.    Prior to its

affiliation with the General Partnership, the Operating

Partnership comprised Beaver Medical Clinic, Inc., and some 30

physician partners, who were also physicians on the medical staff

of Redlands Hospital.
                                 - 5 -

The Affiliation of Redlands Hospital With the Surgery Center

     Before 1990, Redlands Hospital desired to increase its

outpatient surgery capacity but lacked the capital resources and

experience to develop and operate its own freestanding outpatient

facility.     In addition, such a facility would have been in

competition with the existing Surgery Center, and there was

concern that the Redlands community could not sustain both.

         On March 1, 1990, RHS and SCA Centers entered into a

general partnership agreement to acquire jointly a 61-percent

general partnership interest in the Surgery Center.2    The

partnership is known as Redlands Ambulatory Surgery Center (the

General Partnership).

     SCA Centers is a for-profit, wholly owned subsidiary of

Surgical Care Affiliates, Inc. (SCA), a publicly held corporation

based in Nashville, Tennessee, and specializing in owning and

managing ambulatory surgery centers.3    Prior to formation of the

General Partnership, neither SCA nor any of its affiliated

entities had any relationship, contractual or otherwise, with RHS

or any of its affiliated entities, or with the Surgery Center.

     2
       Redlands Hospital is also a signatory to the general
partnership agreement but only with respect to secs. 16 and 17 of
that agreement (regarding noncompetition and affiliated status).
     3
       As of 1995, SCA owned, in whole or part, and operated
approximately 40 ambulatory surgery centers throughout the United
States, some of which were owned in part by tax-exempt health
care systems.
                               - 6 -

     RHS contributed $1,131,289 to the General Partnership,

borrowing $796,829 from SCA and the balance of $334,460 from

Redlands Hospital.   SCA Centers contributed $1,946,993 in cash

and stock to the General Partnership.     In return for its

approximately 37-percent capital investment, RHS received a 46-

percent interest in profits, losses, and cash-flows of the

General Partnership.   In return for its approximately 63-percent

capital investment, SCA Centers received a 54-percent interest in

profits, losses, and cash-flows of the General Partnership.

     The General Partnership agreement provides in relevant part:

                 AGREEMENT OF GENERAL PARTNERSHIP
              OF REDLANDS AMBULATORY SURGERY CENTER

     This AGREEMENT OF GENERAL PARTNERSHIP, [is] entered into as
     of the 1st day of March, 1990, by and between REDLANDS-SCA
     SURGERY CENTERS, INC., a California corporation ("SCA
     Centers") and a wholly owned subsidiary of Surgical Care
     Affiliates, Inc. ("SCA") * * *, RHS Corp., ("RHS") a
     California not-for-profit corporation, * * * and Redlands
     Community Hospital, a California not-for-profit corporation
     (the "Hospital"). SCA Centers and RHS are collectively
     referred to as "Partners."

                            WITNESSETH:

          WHEREAS, RHS desires to insure the
          availability of high quality health services
          in the most cost effective setting in which
          such services can be rendered; and

          WHEREAS, the use of an ambulatory surgical
          center by the area-wide residents will
          contribute to RHS's corporate goal of
          providing comprehensive health care services
          at an affordable price; and

          WHEREAS, SCA is a corporation that is engaged
          in the development and management of
                    - 7 -

ambulatory surgical centers and has the
expertise necessary to operate ambulatory
surgical centers; and

WHEREAS, RHS and SCA Centers desire to enter
into a Partnership to be equally controlled
by representatives of the Partners.

NOW, THEREFORE, in consideration of the
mutual covenants herein contained, SCA
Centers and RHS agree to be partners in a
general partnership (the "Partnership")
pursuant to the California Uniform
Partnership Act (the "Act") on the terms and
conditions hereinafter set forth.

1.   Name and Purpose.

     (a) The Partnership shall be carried on
     under the name of Redlands Ambulatory
     Surgery Center or such other name as may
     be selected by the Managing Directors.
     The Partnership has been formed to
     acquire a 61 percent general partner
     interest (the "General Partner
     Interest") in a California limited
     partnership (the "Operating
     Partnership") which owns and operates a
     freestanding ambulatory surgery center
     in Redlands, California known as the
     Inland Surgery Center (the "Center").
     The Partnership may engage in any and
     all other activities as may be
     necessary, incidental or convenient to
     carry out the business of the
     Partnership as contemplated by this
     Agreement.

          *    *    *       *   *   *   *

3.   Term. The Partnership shall commence on    April 30,
     1990, or such later date as the Partners   shall
     mutually agree, and shall continue until   March 31,
     2020, or such other date as the partners   shall
     mutual [sic] agree.

4.   Management.
               - 8 -

(a) General Management by the Managing Directors.
The general management and determination of all
questions relating to the affairs and policies of
the Partnership, except for questions relating to
the medical standards and medical policies of the
centers, shall be decided by a majority vote of
the Managing Directors. The Managing Directors
shall consist of four (4) persons, two (2) of whom
shall be chosen by SCA Centers and two (2) of whom
shall be chosen by RHS. Notwithstanding the
above, it is recognized that the Managing
Directors have no authority to amend the
Partnership Agreement. In the event the Managing
Directors are unable to agree on a matter, either
Partner may institute the following arbitration
procedure to resolve the matter. Within three (3)
days of a Partner's notifying the other of
institution of this arbitration procedure, each
Partner shall select an arbitrator to resolve the
matter. Within seven (7) days after the selection
of the arbitrators, those arbitrators shall select
a third. Within five (5) days after selection of
the third arbitrator, each Partner shall submit in
writing to each of the arbitrators the Partner's
position on the matter to be resolved. The
arbitrators shall decide the matter and advise the
Partners in writing of their decision within
fourteen (14) days after the Partners' submission
of their written positions. In hearing such
arbitration the arbitrators shall determine the
procedural rules to be applied and shall apply the
substantive law of the State of California without
regard to conflict of law considerations. The
decision of a majority of the arbitrators shall be
final and binding. The costs and expenses of the
arbitrators shall be divided equally between the
Partners.

(b) Medical Advisory Group. The
determination of all questions relating
to the medical standards and medical
policies of the center shall rest with
the Medical Advisory Group. The
determination as to what constitutes a
medical decision, standard or policy
shall rest with the Managing Directors.
The Managing Directors shall select 50
percent of the Medical Advisory Group.
                    - 9 -

     (c) Operating Partnership Agreement and
     Purchase Agreement. RHS hereby
     authorizes SCA Centers to execute on
     behalf of the Partnership: (i) the
     Operating Partnership's Partnership
     Agreement; (ii) an agreement to acquire
     the General Partner Interest (the
     "Purchase Agreement"); and (iii) all
     exhibits to the Purchase Agreement.

          *    *    *       *   *   *   *

12. Management Agreement. The Operating
Partnership shall enter into a Management
Agreement with SCA Management Company, a
wholly-owned subsidiary of SCA ("Management")
whereby Management assumes full
responsibility for administering the day-to-
day operation of the ambulatory center in
accordance with the goals, policies and
objectives of the Operating Partnership. The
Agreement will be for a term of fifteen (15)
years with two (2) five (5) year extensions
at Management's sole discretion and will
provide Management with a fee equal to Six
Percent (6%) of the Operating Partnership's
gross revenues. Legal, accounting, travel,
lodging, meals and other such professional
services associated with the management and
administration of the ambulatory surgery
center shall be reimbursed to Management.

13. Quality Assurance Agreement. Management
shall enter into an [sic] Quality Assurance
Agreement with RHS whereby RHS will agree to
perform certain managerial and supervisory
quality assurance duties in connection with
the operation of the Center. The Quality
Assurance Agreement will continue from year
to year unless terminated by either of the
parties thereto. RHS will receive no fee
under the Quality Assurance Agreement during
the first year thereof and thereafter will be
paid a fee equal to one percent of gross
revenues as defined in such Agreement,
payable monthly.

          *    *    *       *   *   *   *
                    - 10 -

16. Non-Compete. The Partners and RHS
hereby agree that during the term of this
Partnership, and for two years thereafter,
neither party, nor an affiliate of either
party, shall participate in the ownership,
management or development of a free-standing
surgical center which is within those
portions of San Bernardino and Riverside
Counties falling within a twenty (20) miles
radius of the Center unless authorization is
obtained from the other party. Further, the
Hospital shall not expand or promote its
present outpatient surgery program within the
Hospital. Notwithstanding the foregoing in
the event that either Partner acquires the
entire interest of the other Partner herein,
this Section 16 shall not apply thereafter to
the purchasing Partner or its affiliates.

17. Affiliated Status. To the extent
legally permissible, the Hospital agrees to
recognize the surgery center as an affiliate
for managed care contracting purposes (i.e.,
HMOs and PPOs).

18.   New Services and Procedures.

      (a) Exhibit B lists medical services
      and procedures currently available at
      the Center and those which the Partners
      expect to be performed there in the near
      future. SCA Centers acknowledges that
      (1) RHS is an affiliate of the Hospital,
      and (2) that the Hospital enjoys a
      valuable reputation in the area for
      providing quality medical care to
      patients, (3) that the Hospital's
      association with the Center through
      RHS's participation in this Partnership
      will benefit the Center and (4) that RHS
      has an important interest in ensuring
      that services and procedures performed
      at the Center, or by an entity with
      which RHS is associated by virtue of
      this Partnership, within the Hospital's
      service area are only such services and
      procedures which are recognized by a
      majority of the medical community as
                   - 11 -

     being safely and efficaciously performed
     in a non-hospital, outpatient setting.

     (b) Unless otherwise approved by the
     Managing Directors (whose actions in
     matters under this Paragraph shall be
     final and not subject to arbitration or
     review, even if deadlocked), no
     procedures or services currently
     available to patients in the State of
     California which are not listed on
     Exhibit B shall be performed at the
     Center (or by RHS, SCA or the Center
     limited partnership, or an affiliate of
     any of them, excluding the Hospital),
     within the area set forth in Paragraph
     16, unless and until such procedures or
     services are performed or available on a
     non-hospital, outpatient basis at a
     majority of the free-standing outpatient
     surgery facilities in Imperial, Kern,
     Los Angeles, Orange, Riverside, San
     Bernardino, San Diego and Ventura
     Counties.

     (c) With respect to new services or
     procedures which first become available
     in California during the term hereof,
     such services or procedures shall not be
     performed by RHS, SCA, the Center
     limited partnership or an affiliate of
     any of them in the area identified above
     until the Managing Directors determine,
     based on reliable medical evidence
     and/or testimony, that such services and
     procedures can be safely and
     efficaciously performed on a non-
     hospital, outpatient basis.

     *    *    *    *    *    *    *

23. Assignment. Each Partner shall have the
right, without the prior approval of the
other and without triggering the provisions
of paragraph 14 hereof, to transfer or assign
all or any part of its interest in this
Partnership to an affiliated entity; * * *
in the event either Partner assigns its
                              - 12 -

          interest hereunder the provisions of Section
          16, shall continue to apply to the assignor,
          as well as to the assignee, and the interest
          held by the assignee shall be subject to
          repurchase as provided in Section 19 hereof,
          upon the breach of Section 16 by the
          assignor, the assignee [or] their Affiliates.

The General Partnership’s Acquisition of the Operating
Partnership Interest

     Effective April 30, 1990, the General Partnership entered

into an amended and restated agreement of the Operating

Partnership in accordance with the Revised Limited Partnership

Act of the State of California.   Pursuant to this agreement, the

General Partnership acquired, for approximately $3 million, a 61-

percent general partnership interest in the Operating

Partnership.4   As part of the purchase price, the General

Partnership agreed to contribute $1,598,495 by delivering to the

limited partners (with the exception of Beaver Medical Clinic)

shares of SCA common stock with an equivalent market value.5

     4
       Prior to Apr. 30, 1990, the three general partners of the
Operating Partnership were two individuals who had aggregate
ownership interests of 24 percent, and Beaver Medical Clinic,
Inc., which had a 6-percent ownership interest. Effective Apr.
30, 1990, the two individual general partners sold their
aggregate 24-percent interests, and Beaver Medical Clinic, Inc.
converted its 6-percent general partner interest into a 10.3-
percent limited partner interest. The other limited partners are
physicians who are also on the medical staff of Redlands
Hospital.
     5
       The General Partnership subsequently reduced its ownership
interest in the Operating Partnership to 59 percent as a result
of the sale of 2 percent of the general partner interest to a
                                                   (continued...)
                              - 13 -

     To determine the General Partnership’s investment, the

Operating Partnership was valued at four to five times earnings.

No formal appraisal was acquired; rather, the valuation was

determined based on SCA’s experience and knowledge of the market

and by a review of historical records.   An unrelated bidder (a

for-profit company, not otherwise identified in the record) was

offering the Operating Partnership a higher purchase price based

on approximately six times earnings.   The existing partners of

the Operating Partnership agreed to the offer made by the General

Partnership due to the desire to have an affiliation with

Redlands Hospital for quality control review and other reasons,

such as to supervise the teaching and maintenance of up-to-date

surgery methodologies.

     The General Partnership is the sole general partner of the

Operating Partnership.   There are 32 limited partners.   Except

for Beaver Medical Clinic, Inc., the limited partners are all

physicians who are also on the medical staff of Redlands

Hospital.   Two of the limited partners are board members of

Redlands Hospital and RHS.   The amended Operating Partnership

agreement contains no statement of charitable purpose and imposes

no requirement that the Operating Partnership operate for a

     5
      (...continued)
physician, with that interest then being converted to a limited
partner interest. The limited partners currently have a 41-
percent interest in the Operating Partnership.
                                   - 14 -

charitable purpose.    Relevant portions of the amended Operating

Partnership agreement are set out below:

         AMENDED AND RESTATED CERTIFICATE AND AGREEMENT
                     OF LIMITED PARTNERSHIP
                 OF INLAND SURGERY CENTER, L.P.

                       *    *      *    *      *   *   *

                             IV.    BUSINESS

          The business of the Partnership is to own and operate
     the Center and to carry on any and all activities necessary,
     proper, convenient, or advisable in connection therewith.

                       *    *      *    *      *   *   *

              VI.     CAPITAL CONTRIBUTION, STATUS AND
                       ADDITIONAL WORKING CAPITAL

          6.1 Capital Contribution of the General Partner. Upon
     execution of this Agreement, the General Partner will
     contribute $1,979,077 to the Partnership to be paid
     $1,655,842 by check or by wire transfer and $1,598,495 by
     delivering Shares,[6] which shall be simultaneously
     distributed to the Limited Partners, other than [Beaver
     Medical Clinic], in the amounts set forth on Schedule C.
     For purposes of payment of the contribution, the Shares
     shall be valued at the average of the closing prices of the
     Shares, as reported by the NASDAQ National Market System, on
     each of the five trading days which are prior to the ten
     business days prior to April 30, 1990.

                       *    *      *    *      *   *   *

               SCA will also make available to each Limited
     Partner, other than [Beaver Medical Clinic], appropriate
     officers of SCA who will respond to questions relating to
     the material furnished and the business and affairs of SCA.

               The Limited Partners who receive such shares shall
     not sell, exchange, pledge hypothecate or otherwise dispose

     6
       Paragraph 1.25 of the Operating Partnership agreement
defines “Shares” as “$.01 par value common stock of SCA”.
                           - 15 -

 of the shares prior to the date six months have elapsed from
 the date this Agreement is executed. In any transfer of the
 Shares, the Limited Partners shall comply with the
 prospectus delivery requirements of the Securities Act of
 1933.

                 *    *    *    *    *     *    *

           7.3 Management Fees. SCA Management Company, a
 subsidiary of SCA, will enter into a Management Agreement
 with the Partnership pursuant to which SCA Management
 Company will provide management, purchasing and other
 services and support to the Partnership. SCA Management
 Company will be reimbursed for any direct costs incurred in
 managing the Partnership and will be paid an annual
 management fee equal to 6% of the Partnership’s Gross
 Revenues payable monthly.

VIII.   ALLOCATION OF INCOME AND LOSS:   CASH DISTRIBUTIONS

           8.1 Available Cash Flow. The Partnership shall
 distribute Available Cash Flow and any other property
 received by the Partnership as a result of the operations of
 the Center or sale of its assets (a) 1.1366% to the holder
 of each outstanding Unit,(b) 10.3% to [Beaver Medical
 Clinic] and (c) the balance to the General Partner.

                 *    *    *    *    *     *    *

           8.4 Profits and Losses. Profits and losses shall
 be allocated 10.3% to [Beaver Medical Clinic], 1.1366% to
 the holder of each Unit and the balance to the General
 Partner. * * *

                 *    *    *    *    *     *    *

IX.   RIGHTS, POWERS AND OBLIGATIONS OF THE GENERAL PARTNER

           9.1 Powers. The management and control of the
 Partnership and its business and affairs shall rest
 exclusively with the General Partner, which shall have all
 the rights and powers which may be possessed by a general
 partner pursuant to the Act, and such additional rights and
 powers as are otherwise conferred by law or are necessary,
 advisable or convenient to the discharge of its duties under
 this Agreement. The General Partner shall be the “tax
 matters partner” within the meaning of the Code. Without
                        - 16 -

limiting the generality of the foregoing, the General
Partner may, at the cost, expense and risk of the
Partnership:

               9.1.1. Spend the capital and net income of
          the Partnership in the exercise of any rights or
          powers possessed by the General Partner hereunder;

               9.1.2. Lease the Land, manage and operate
          the Center and enter into agreements containing
          such terms, provisions and conditions as the
          General Partner in its discretion shall approve;

               9.1.3. Purchase from or through others
          contracts of liability, casualty and other
          insurance which the General Partner deems
          advisable for the protection of the Partnership or
          for any purpose convenient or beneficial to the
          Partnership;

               9.1.4. Incur indebtedness in the ordinary
          course of business;

               9.1.5. Subject to the provisions of Section
          9.4.1.2 of this Agreement, sell or otherwise
          dispose of, upon such terms and conditions as the
          General Partner may deem advisable, appropriate or
          convenient, any of the assets of the Partnership;

               9.1.6. Invest in short-term debt obligations
          (including obligations of federal and state
          governments and their agencies, commercial paper
          and certificates of deposit of commercial banks,
          savings banks or savings and loan associations)
          and “money market” mutual funds, such funds as are
          temporarily not required for the purposes of the
          Partnership’s operations; and

               9.1.7. Delegate all or any of its duties
          hereunder and, in furtherance of any such
          delegation, appoint, employ, or contract with any
          person (including affiliates of the General
          Partner) for the transaction of the business of
          the Partnership, which persons may, under the
          supervision of the General Partner, act as
          consultants, accountants, attorneys, brokers,
          escrow agents, or in any other capacity deemed by
          the General Partner necessary or desirable, and
                            - 17 -

            pay appropriate fees to any of such persons;
            provided, however, the General Partner shall not
            delegate duties hereunder which are required to be
            performed by SCA Management Company under the
            Management Agreement.

     9.2. Independent Activities. Subject to the
provisions of Section 16.2 of this Agreement, the General
Partner and each Limited Partner may, notwithstanding the
existence of this Agreement, engage in whatever activities
they choose, whether or not the same be competitive with the
Partnership, without having or incurring any obligation to
offer any interest in such activities to the Partnership or
any party hereto, and, as a material part of the
consideration for the General Partner’s execution hereof and
for the admission of such Limited Partner, each Limited
Partner hereby waives, relinquishes and renounces any such
right or claim of participation.

     9.3. Duties. The General Partner shall manage and
control the Partnership, its business and affairs to the
best of its ability and shall use its best efforts to carry
out the business of the Partnership. The General Partner
shall devote itself to the business of the Partnership to
the extent that it, in its discretion, deems necessary for
the efficient carrying on thereof. The General Partner
shall act as a fiduciary with respect to the safekeeping and
use of the funds and assets of the Partnership.

     9.4.    Certain Limitations.

                 9.4.1 Without obtaining the consent of all
            of the Partners, the General Partner shall not:

                 9.4.1.1.   Act in contravention of this
            Agreement;

                 9.4.1.2. Except as provided in Article XII
            of this Agreement, do any act which would make it
            impossible to carry on the ordinary business of
            the Partnership;

                 9.4.1.3.   Confess a judgment against the
            Partnership;

                 9.4.1.4. Assign the Partnership property in
            trust for creditors or on the assignee’s promise
            to pay the debts of the Partnership;
                          - 18 -

               9.4.1.5. Submit a Partnership claim or
          liability to arbitration or reference; or

               9.4.1.6.   Dispose of the goodwill of the
          Partnership.

                *    *    *    *    *    *    *

     9.6. Medical Advisory Group. The Partnership shall
have a Medical Advisory Group consisting of six Limited
Partners appointed annually. Three members of the Medical
Advisory Group shall be appointed by [Beaver Medical
Clinic]. The three remaining members shall be appointed by
the General Partner. Vacancies in the Medical Advisory
Group shall be filled in accordance with the above
procedure. Subject to law regulations, and the standards of
applicable regulatory bodies, the medical standards of the
Partnership will be under the control of the Medical
Advisory Group. The General Partner will determine what are
medical standards and policies.

                *    *    *    *    *    *    *

     10.4 Government Regulation. In the event that, in the
opinion of counsel to the Partnership, the referral of
Medicare or any other patients to the Center by Partners
becomes illegal, the Partnership shall require each Limited
Partner to offer his interest to the General Partner for
five times the reportable taxable income allocated to that
interest on the Partnership Return for the tax year
immediately preceding the year in which counsel determines
such reference is illegal. Up to 50% of the purchase price
shall, at the option of the General Partner, be paid in
unregistered Shares. The General Partner shall have 30 days
in which to accept such offer.

                *    *    *    *    *    *    *

         XV.   LIABILITY OF THE GENERAL PARTNER

     15.1. Return of Capital Contribution. Anything in
this Agreement to the contrary notwithstanding, the General
Partner shall not be individually liable for the return of
the Capital Contributions of the Limited Partners, or any
portion thereof, it being expressly understood that any such
return shall be made solely from Partnership assets.
                        - 19 -

     15.2. Exculpation and Indemnification. The doing of
any act or the failure to do any act by the General Partner
shall not subject the General Partner to any liability to
the Partnership or the Partners, except for gross negligence
or willful malfeasance. The Partnership shall indemnify the
General Partner against losses sustained in connection with
the Partnership, provided that the losses were not the
result of gross negligence, self-dealing or willful
malfeasance on the part of the General Partner.

               *    *    *    *    *    *    *

     16.5. Amendments. Amendments to this Agreement may be
proposed by the General Partner or Limited Partners with a
Limited Partnership Percentage in excess of 50%.

               *    *    *    *    *    *    *

     16.5.2. In addition to any amendments otherwise
authorized herein, the General Partner may, without
obtaining the consent of the Limited Partners, amend this
Agreement from time to time:

          (a) To add to the representations, duties or
          obligations of the General Partner or its
          affiliates or surrender any right or power granted
          to the General Partner or its affiliates herein,
          for the benefit of the Limited Partners; and

          (b) To cure any ambiguity, to correct or
          supplement any provision herein * * * which may be
          inconsistent with any other provision herein, or
          to make any other provisions with respect to
          matters or questions arising under this Agreement
          * * * as the case may be, which will not be
          inconsistent with the provisions of this Agreement
          * * *, provided that the Partnership receives a
          written opinion of independent counsel that such
          amendment does not adversely [a]ffect the
          interests of the Limited Partners.

               *    *    *    *    *    *    *

          (e) Upon advice of counsel that the operations of
          the Partnership are in violation of law, to cause
          this Agreement to comply with law; provided,
          however, such amendments shall not alter
          materially the economic objectives of the
                             - 20 -

               Partnership and, further, provided that any
               amendment to or deletion of any provision shall
               not in the opinion of the General Partners
               materially reduce the economic return to the
               Limited Partners.

The Management Contract With SCA Management

     Pursuant to the provisions of paragraph 12 of the General

Partnership agreement, supra, and paragraph 7.3 of the Operating

Partnership agreement, supra, on April 30, 1990, the Operating

Partnership entered into a contract with SCA Management, whereby

SCA Management was retained “for the purpose of rendering

management, administration and purchasing services and support,

and all other management support needed for operation and, in the

best interest, of the [Surgery] Center”.   The management

agreement is signed on behalf of both the Operating Partnership

and SCA Management by David E. Crockett, in his capacities as

secretary and vice president, respectively, of these two

entities.

     Pursuant to the management contract, SCA Management has

wide-ranging authority for operational management of the Surgery

Center, except that it has “no power or authority to make any

decision relating to the care or treatment of patients or other

medical matters”, this power and authority being specifically

reserved to the Operating Partnership’s Medical Advisory
                                - 21 -

Committee.7    SCA Management is authorized to enter into contracts

relating to the affairs of the Surgery Center, subject to certain

exceptions, requiring express authorization of the Operating

Partnership.    These exceptions include lease or contractual

obligations requiring payments in excess of $50,000 in any 12-

month period, and obligations to a related party in excess of

$5,000.

     The management contract states that SCA Management is

authorized to provide services to the Operating Partnership

(referred to as “the Owner” in the following quoted provisions),

as follows:

                      II.   MANAGEMENT SERVICES

          1.    Subject to the provisions of Article I, the
     Manager will render all services, direction, advice,
     supervision and assistance in the operation of the Center,
     as necessary, including, but not in any way limited to, the
     following:

               A. Maintaining the accreditation of the Center
          with the proper agencies and insurance companies;

               B. Arranging for the purchase by the Owner of
          hazard, liability, professional and other necessary
          insurance coverage for the Center; provided, however,
          that the physicians practicing in the Center shall
          obtain their own malpractice insurance;

               C. Employing, supervising, directing, leasing and
          discharging on behalf of the Owner, all non-physician
          personnel performing services at the Center, including

     7
       Under paragraph 9.6 of the Operating Partnership
agreement, the general partner (i.e., the General Partnership)
determines what are medical standards and policies.
                         - 22 -

     the administrator of the Center, as needed. The
     administrator shall be subject to the Owner's approval.

          D. Negotiating fee payment methods, including
     Medicare reimbursement, with the appropriate third
     party payers and state and federal agencies;

          E. Establishing staffing schedules, wage
     structures and personnel policies for all personnel;

          F. Determining and setting patient charges for
     services provided by the Center, excluding charges for
     physicians' services, and arranging for payment of such
     charges by others, when appropriate;

          G. Providing administrative policies and non-
     medical operating procedures to all departments;

          H. Providing standard formats for all charts,
     invoices and other forms used in the operation of the
     Center;

          I. Providing for the purchase or lease by the
     Owner of all supplies and equipment used in the
     operation of the Center;

          J. Directing the day-to-day operations of the
     Center to insure the operations are conducted in a
     business-like manner;

          K. Developing an ongoing advertising and
     promotion program;

          L. Negotiating or retaining on behalf of the
     Owner contractual relationships for anesthesiology,
     radiology and pathology services, as appropriate; and

          M. Performing all management and non-medical
     oversight responsibilities for the Owner.

     2. All costs and expenses incurred with respect to the
services specified in Paragraph 1 above will be borne by the
Manager.

       III.   ACCOUNTING AND BOOKKEEPING SERVICES

     1. The Manager agrees to review, direct and supervise
the following accounting and bookkeeping services for the
Owner in the operation of the Center.
                    - 23 -

     A. Receipt for and deposit in a special bank
account selected by the Owner, separate from all other
monies of the Manager, all funds received from the
operation of the Center and supervise the disbursement
of such funds for the operating expenses of the Center;

     B. Maintain the books of account, including all
journals and ledgers, check register and payroll
records;

     C. Post all patient and other charges, including
necessary analysis and corrections;

     D. Establish adequate receivable, credit and
collection policies and procedures;

     E. Process vendor's invoices and other accounts
payable;

     F. Prepare payroll checks from time sheet
summaries prepared under the Manager's supervision;

     G. Prepare payroll and supervise preparation of
the Owner's tax returns (fees paid to independent
accountants will be the responsibility of the Owner);

     H.   Prepare monthly bank reconciliations;

     I. Prepare and distribute to the Owner monthly
profit and loss statements;

     J. Establish patient insurance billing
procedures;

     K. Furnish the Owner on or before the 30th day
following the end of each calendar quarter (i) an
accrual basis balance sheet of the Owner at the end of
the previous quarter and (ii) an accrual basis
statement of income for the quarter then ended of
"available cash" at the end of such quarter and (iii) a
list of all outstanding and unpaid obligations of the
Owner at the end of such quarter. * * *

     L. Furnish the Owner for its approval, during the
fourth quarter of each fiscal year, the operating
budget and capital expenditure budget of the Center for
the next fiscal year.
                               - 24 -

     Under the management contract, SCA Management is entitled to

receive a monthly management fee equal to 6 percent of gross

revenues, defined as the net collectable portion of revenues

billed as fees or other charges arising out of the operation of

the Surgery Center, with no deduction for bad debts.   In

addition, SCA Management is entitled to be reimbursed for direct

expenses incurred in managing the Surgery Center.    The Operating

Partnership is required to approve any single expense in excess

of $5,000.

     The term of the management contract is equal “to the term of

any indebtedness, lease or other obligation of the * * *

[Operating Partnership] guaranteed by SCA or an affiliate of SCA

but not less than 15 years.”   The management agreement is

renewable by SCA Management at its option for two 5-year terms.

Except for circumstances involving bankruptcy or insolvency, the

management contract is terminable by the Operating Partnership

only if SCA Management breaches the agreement, and then generally

only after a 90-day notice and 90-day cure period.

Managing Directors of the General Partnership

     As indicated in paragraph 4 of the General Partnership

agreement, supra, overall management of the General Partnership,

except for questions of medical standards and medical policies,

is vested in its managing directors, consisting of four persons,

two of whom are appointed by petitioner, and two of whom are
                               - 25 -

appointed by SCA Centers.   The managing directors of the General

Partnership meet on a quarterly basis.    Their activities and

responsibilities include:

          a.     Developing and approving the Surgery Center's

     capital and operating budgets;

          b.     Approving distributions of the Surgery Center's

     earnings;

          c.     Hiring and firing the Surgery Center's manager;

          d.     Reviewing the Surgery Center's financial results;

          e.     Reviewing proposed capital equipment purchases of

     the Surgery Center;

          f.     Appointing one-half of the members of the Surgery

     Center Medical Advisory Committee;

          g.     Facilitating the lending of equipment from

     Redlands Hospital to the Surgery Center;

          h.     Reviewing the Surgery Center's use of nursing

     staff;

          i.     Coordinating training and mentoring opportunities

     between Redlands Hospital and the Surgery Center;

          j.     Approving any long-term debt obligations;

          k.     Approving any obligations for repairs, equipment,

     additions, or betterments to the Surgery Center;

          l.     Approving any lease or contractual obligations

     requiring payments in excess of $50,000 in the aggregate for
                              - 26 -

     any twelve-month period or those obligations not in the

     ordinary course of business; and

          m.   Approving any obligation to a related party in

     excess of $5,000.

Quality Assurance Agreement

     Paragraph 13 of the General Partnership agreement, supra,

requires SCA Management to enter into a quality assurance

agreement with RHS whereby RHS will agree to perform “certain

managerial and supervisory quality assurance duties” in

connection with the operation of the Surgery Center.     The General

Partnership agreement provides that the quality assurance

agreement is to continue from year to year unless terminated by

either of the parties.

     Effective April 30, 1990, SCA Management and RHS entered

into a quality assurance agreement.     The agreement states that

SCA Management “retains RHS for the purpose of the management and

supervision of quality assurance programs for the [Surgery]

Center and [to] oversee its affairs, and for providing additional

services as SCA [Management] may reasonably request.”

     The quality assurance agreement recites as one of its

premises that SCA Management “desires to reimburse RHS for

certain services, including without limitation management and the

supervision of quality assurance programs with respect to the

[Surgery] Center.”   Under the quality assurance agreement, RHS
                                - 27 -

was to receive no fee during the first year and thereafter was to

be paid a monthly fee equal to 1 percent of gross revenues.       In

addition, SCA Management was to reimburse RHS for its direct out-

of-pocket expenses incurred in managing and supervising the

quality assurance program.     The quality assurance agreement

states that RHS' appointees as managing directors shall not

receive any compensation from SCA Management, but that SCA

Management shall reimburse them for all reasonable travel

expenses and out-of-pocket expenses.

     On September 30, 1990, RHS transferred its obligations and

rights under the Quality Assurance Agreement to petitioner.

     By its terms, the quality assurance agreement was to

continue from year to year unless terminated by either SCA

Management or petitioner.     The quality assurance agreement was to

terminate automatically, however, if the number of surgical cases

performed at the Surgery Center was less than 4,225 during any

year.     The agreement states that if it is terminated for any

reason, the parties agree to negotiate in good faith an agreement

on substantially the same terms.

Medical Advisory Group

        Pursuant to paragraph 9.6 of the Operating Partnership

agreement, supra, all questions regarding medical standards and

policies at the Surgery Center are determined by a Medical

Advisory Group, which also reviews procedures being performed at
                              - 28 -

the Surgery Center.   The Medical Advisory Group is composed of

six physicians who are all limited partners of the Operating

Partnership.   The managing directors of the General Partnership

select three members of the medical advisory group; Beaver

Medical Clinic--which is a limited partner in the Operating

Partnership--selects the other three members.   Prior to the

affiliation of the General Partnership with the Surgery Center,

the Medical Advisory Group was inactive.

Redlands Surgical Services (Petitioner)

     On August 1, 1990, 5 months after entering into the General

Partnership agreement, RHS incorporated petitioner as a

California nonprofit public benefit corporation.   On September

30, 1990, RHS transferred its interest in the General Partnership

to petitioner.

     RHS formed petitioner with the intent that petitioner's sole

planned activity would be its efforts with respect to the

Operating Partnership.   The decisions to incorporate petitioner

as a separate corporate entity and to transfer the interests in

the General Partnership to petitioner were made to protect

Redlands Hospital and Redlands Foundation from potential

creditors of the Surgery Center and to keep petitioner's and the

Surgery Center's activities free of the debt covenants of

Redlands Hospital.
                              - 29 -

    Petitioner’s articles of incorporation state in relevant

part:

    ONE:        The name of this Corporation is REDLANDS SURGICAL
                SERVICES.

    TWO:        This Corporation is a nonprofit public benefit
                corporation and is not organized for the private
                gain of any person. It is organized under the
                Nonprofit Public Benefit Corporation Law for
                charitable purposes. The corporation is organized
                solely for the benefit of, and to carry out the
                charitable purposes as stated in the respective
                Articles of Incorporation of (a) RHS Corp., a
                California nonprofit corporation, (b) Redlands
                Community Hospital, a California nonprofit
                Corporation, and (c) Redlands Community Hospital
                Foundation, a California nonprofit corporation.

                     *    *    *    *    *    *    *

        FOUR:   (a) The property of this corporation is
                irrevocably dedicated to charitable purposes, and
                no part of the net income or assets of this
                corporation shall ever inure to the benefit of any
                director, officer or member of this corporation,
                or to the benefit of any private individual.

                     *    *    *    *    *    *    *

        FIVE:   (a) This corporation is organized exclusively for
                charitable purposes within the meaning of Section
                501(c)(3) of the Internal Revenue Code.
                Notwithstanding any other provisions of these
                Articles, the corporation shall not carry on any
                activities not permitted to be carried on (i) by a
                corporation exempt from Federal income tax under
                Section 501(c)(3) of the Internal Revenue Code of
                1954, as amended (or the corresponding provision
                of any future United States Internal Revenue Law
                or (ii) by a corporation, contributions to which
                are deductible under Section 170(c)(2) of the
                Internal Revenue Code of 1954, as amended (or the
                corresponding provision of any future United
                States Internal Revenue Law).
                               - 30 -

     Petitioner's bylaws limit membership to one member.      The

sole member is RHS, which has the right to elect, remove, and

fill vacancies in petitioner's Board of Directors.    Petitioner's

bylaws provide that the directors must be among those persons

serving as members of the Enterprise Committee of petitioner's

parent corporation RHS.

     Petitioner's sole source of financial support is its share

of the revenues from the Operating Partnership.     Petitioner has

no paid or salaried employees.    The president of Redlands

Hospital serves concurrently as petitioner’s president.

The Surgery Center's Operations

     The Surgery Center operates on a nondiscriminatory basis

both as to doctors and patients.    There are no restrictions as to

whether a surgical patient can be operated on at the Surgery

Center, other than a review as to the appropriateness of

conducting the surgical procedure in an outpatient setting and

the overall medical condition of the patient.    There is

practically a 100-percent overlap between surgeons who operate at

Redlands Hospital and at the Surgery Center.

     Between 1990 and 1995, the number of surgical procedures

performed at the Surgery Center increased 10 percent.    Over the

same period, the number of outpatient surgeries performed at

Redlands Hospital decreased from 2,239 to 1,864.8

     8
         The administrative record does not reflect the number of
                                                     (continued...)
                              - 31 -

Procedures Authorized To Be Performed at the Surgery Center

     The General Partnership agreement specifies the types of

medical services and procedures to be available at the Surgery

Center, which include:   Arthroscopic surgeries, laproscopic

surgeries (including hysterectomies and appendectomies),

conizations, tonsillectomies, herniorrhaphy and eye surgeries.

When such procedures involve a higher-risk patient, they are

performed at Redlands Hospital or another acute-care hospital.

The decision to perform surgery at a hospital rather than at the

Surgery Center is exclusively a medical decision.

     The General Partnership agreement generally provides that,

unless otherwise approved by the managing directors, the Surgery

Center will not perform new surgical procedures until they are

available on a nonhospital, outpatient basis at a majority of

freestanding outpatient surgery facilities in the area.    If the

managing directors deadlock over approval of new procedures, the

arbitration provisions of the partnership agreement do not apply

to break the deadlock.

     Petitioner's appointees to the managing directors have

successfully blocked various proposals by SCA Centers that

additional surgical procedures be conducted at the Surgery

Center.   For example:

     8
      (...continued)
outpatient surgical procedures performed at the Surgery Center or
Redlands Hospital since 1995.
                          - 32 -

-- SCA Centers requested that Redlands Hospital transfer all

of its outpatient surgery volume to the Surgery Center.

Petitioner's appointees to the managing directors, however,

did not feel that this was an appropriate use of the

facility nor in the best interests of Redlands Hospital and

voted against this proposal.   As a result, outpatient

surgeries continue to be performed at Redlands Hospital.

-- SCA Centers proposed that the Surgery Center offer new

surgical procedures that would require the patient to stay

overnight to recover.    Petitioner's representatives did not

think this was an appropriate service to offer at the

Surgery Center and voted against performing these procedures

at the Surgery Center.   As a result, surgical procedures

that require 24-hour recovery time are performed at a

hospital.

-- SCA Centers proposed that physicians be permitted to

perform retinal attachments at the Surgery Center and

requested that the Surgery Center purchase the necessary

equipment for the surgical procedure.   Petitioner did not

believe there was sufficient volume in the Redlands patient

community to maintain quality control over this type of

surgery, and so its two appointees to the managing directors

voted against the purchase of the equipment and the
                               - 33 -

     performance of this type of eye surgery at the Surgery

     Center.

     In addition, petitioner’s appointees to the board of

directors voted against SCA Center’s proposal to bill on behalf

of Redlands Hospital for outpatient surgeries performed there.

Payment for Services

     The Surgery Center's charges are determined on the basis of

customary and usual charges for similar services provided by

other organizations in the area.   The Surgery Center offers no

free care to indigents and has no emergency room or certification

to treat the emergency patient population.      For persons who are

unable to pay, an effort is made to provide all necessary

services and to assist the patient in qualifying for appropriate

medical coverage including Medi-Cal.      The Surgery Center also

provides payment plans for patients to make payment for

procedures more affordable.

     Since the General Partnership acquired its interest in the

Operating Partnership, the Surgery Center has accepted more

managed care (i.e., care provided by health maintenance

organizations (HMO's)).   Prior to April 1990, the Surgery Center

had HMO contracts with 7 HMO's and preferred provider

organizations (PPO's).    As of April 1994, the Surgery Center had

contracts with 21 HMO's and PPO's.      For the last 6 months of

1993, managed care (i.e., care provided by HMO's and PPO's)
                              - 34 -

accounted for almost half of the Surgery Center's total facility

invoices.   The General Partnership agreement states that Redlands

Hospital agrees to recognize the Surgery Center as an affiliate

for managed care services to the extent legally permissible.

      For the last 6 months of 1993, Medicare accounted for about

12 percent of total Surgery Center invoices.    Because greater

medical risks attend surgery of older patients, such as the

typical Medicare patient, most Medicare surgeries are performed

in a hospital setting, rather than in a surgery center.

     Medicaid reimbursements are substantially below those

provided by Medicare.   Medi-Cal is the State of California's

Medicaid program under Federal law.    The California Medi-Cal

patient group consists, in large part, of indigents, mothers, and

children.   These patients' greatest needs are for emergency room

and obstetrics and gynecology (OB/GYN) medical service.    As a

result, this group of patients is more likely to avail themselves

of the emergency room facilities at Redlands Hospital rather than

either Redlands Hospital's or the Surgery Center's surgical

facilities.

     The Surgery Center has no contract with Medi-Cal directly,

although a negligible amount of Medi-Cal coverage is provided for

surgeries performed at the Surgery Center pursuant to

participating hospital agreements between Redlands Hospital and

the Blue Cross of California Medi-Cal Managed Care Program,

effective December 1, 1994, and between Redlands Hospital and
                                - 35 -

PacifiCare of California, a California HMO, effective June 1,

1994.     For the last 6 months of 1993, the Surgery Center's

Medicaid invoices totaled 18, or less than 1 percent (8/10 of 1

percent) of all its invoices.

Integration of the Activities of Redlands Hospital and the
Surgery Center

        Since its affiliation with the General Partnership, the

Surgery Center has served as a training site for Redlands

Hospital nurses in outpatient procedures.     Redlands Hospital

nursing surgery staff members train at the Surgery Center in

circumstances where the frequency of a particular surgery at the

Surgery Center makes such training more efficient and economical.

This is especially true of procedures that are more often

performed at the Surgery Center than at Redlands Hospital (e.g.,

tonsillectomy and cataract surgeries).

        To be a member of the Redlands Hospital physician staff, a

physician must be board-certified in his or her specialty and

regarded by Redlands Hospital as a capable practitioner.

Redlands Hospital uses a "proctory" review process to approve new

members of its physician staff.     Before the General Partnership

acquired its interest in the Surgery Center, no proctoring was

conducted at the Surgery Center.     Since the affiliation of the

Surgery Center with the General Partnership, it is frequently the

case that, as new surgeons join Redlands Hospital's staff, the
                              - 36 -

Redlands Hospital proctoring requirements are satisfied, in whole

or in part, during surgeries performed at the Surgery Center.

     Redlands Hospital has been involved in teaching new

procedures to be performed at the Surgery Center.   An example is

laser arthroscopic surgery, which eliminates incision.     These

procedures were developed at Redlands Hospital, and the knowledge

was shared with the Surgery Center.

The Surgery Center’s Financial Results

     The Surgery Center’s profit levels and payor mix are

comparable to other ambulatory surgery centers.   Its profits are

used for equipment additions, replacements, improvements in

services, and cash distributions to the partners.

     In the first 5-month period after April 30, 1990, when the

amended Operating Partnership and the SCA Management contract

became effective, the Operating Partnership had net income of

$451,430, which was 34.5 percent of gross revenues.   SCA

Management received $80,458 in fees.

     Cash distributions from the Operating Partnership to

petitioner, SCA Centers, and the limited partners, expressed as

an average rate of return on investment basis for fiscal years

1990-1993, were as follows:
                                - 37 -

                       Average Rates of Return

                 FY90        FY91     FY92       FY93      FY90-FY93

Petitioner       6.3%        24.9%    34.9%      43.5%      27.4%

SCA Centers      4.4%        17.3%    25.4%      31.5%      19.6%

Limited Partners 5.1%        21.4%    31.0%      38.5%      24.0%

     Upon its Form 1023, Application for Recognition of

Exemption, under section 501(c)(3), filed August 7, 1990,

petitioner estimated that between 50 and 80 percent of its total

annual income would be used to support RHS and Redlands Hospital,

which were stated to have total annual losses of $340,544 and

$460,595, respectively.    Petitioner has used its share of the

cash distributions from the Operating Partnership to pay off the

note payable to SCA for its initial capital contribution9 and to

make distributions to RHS or Redlands Hospital.

Final Adverse Ruling

     In its final adverse ruling, respondent determined that

petitioner is "not operated exclusively for charitable purposes

within the meaning of section 501(c)(3).      You are operating for a

substantial nonexempt purpose and your operations benefit private

interests more than incidentally."

     9
       The note payable to SCA of $769,829 was paid in full by
April 1992.
                                 - 38 -

     Petitioner has exhausted its administrative remedies within

the Internal Revenue Service.

                                OPINION

                      I.   The Parties’ Positions

     Respondent contends that petitioner is not operated

exclusively for charitable purposes because it operates for the

benefit of private parties and fails to benefit a broad cross-

section of the community.     In support of its position, respondent

contends that the partnership agreements and related management

contract are structured to give for-profit interests control over

the Surgery Center.    Respondent contends that both before and

after the General Partnership acquired an ownership interest in

it, the Surgery Center was a successful profit-making business

that never held itself out as a charity and never operated as a

charitable health-care provider.

     Petitioner argues that it meets the operational test under

section 501(c)(3) because its activities with regard to the

Surgery Center further its purpose of promoting health for the

benefit of the Redlands community, by providing access to an

ambulatory surgery center for all members of the community based

upon medical need rather than ability to pay, and by integrating

the outpatient services of Redlands Hospital and the Surgery

Center.   Petitioner argues that its dealings with the for-profit

partners have been at arm's length, and that its influence over
                                - 39 -

the activities of the Surgery Center has been sufficient to

further its charitable goals.    Petitioner further contends that

it qualifies for exemption because it is organized and operated

to perform services that are integral to the exempt purposes of

RHS, its tax-exempt parent, and Redlands Hospital, its tax-exempt

affiliate.

                 II.    Applicable Legal Principles

A.   Operational Test

     To qualify for exemption from Federal income tax, an

organization must be “organized and operated exclusively for

* * * charitable * * * purposes”.    Sec. 501(c)(3); see Church of

Scientology v. Commissioner, 823 F.2d 1310, 1315 (9th Cir. 1987),

affg. 83 T.C. 381 (1984).

     The applicable regulations provide as follows:

          (c) Operational test--(1) Primary activities. An
     organization will be regarded as “operated exclusively” for
     one or more exempt purposes only if it engages primarily in
     activities which accomplish one or more of such exempt
     purposes specified in section 501(c)(3). An organization
     will not be so regarded if more than an insubstantial part
     of its activities is not in furtherance of an exempt
     purpose. [Sec. 1.501(c)(3)-1(c)(1), Income Tax Regs.]

     The operational test focuses on the actual purposes the

organization advances by means of its activities, rather than on

the organization's statement of purpose or the nature of its

activities.   See American Campaign Academy v. Commissioner, 92

T.C. 1053, 1064 (1989); Goldsboro Art League, Inc. v.
                                - 40 -

Commissioner, 75 T.C. 337, 343 (1980); Aid to Artisans, Inc. v.

Commissioner, 71 T.C. 202, 210-211 (1978).     To determine whether

the operational test has been satisfied, we look beyond “the four

corners of the organization’s charter to discover 'the actual

objects motivating the organization'”.     American Campaign Academy

v. Commissioner, supra at 1064.

     Although an organization might be engaged in only a single

activity, that single activity might be directed toward multiple

purposes, both exempt and nonexempt.     If the nonexempt purpose is

substantial in nature, the organization will not satisfy the

operational test.   See KJ’s Fund Raisers, Inc. v. Commissioner,

166 F.3d 1200 (2d Cir. 1998), affg. without published opinion

T.C. Memo. 1997-424; Manning Association v. Commissioner, 93 T.C.

596, 603-605 (1989); American Campaign Academy v. Commissioner,

supra at 1065; Copyright Clearance Ctr., Inc. v. Commissioner, 79

T.C. 793, 804 (1982).    “The presence of a single * * * [non-

exempt] purpose, if substantial in nature, will destroy the

exemption regardless of the number or importance of truly * * *

[exempt] purposes.”     Better Bus. Bureau, Inc. v. United States,

326 U.S. 279, 283 (1945).

     The fact that an organization engages in a trade or business

is not conclusive of a substantial nonexempt purpose and does

not, in and of itself, disqualify the organization from exemption

under section 501(c)(3), provided the activity furthers or
                               - 41 -

accomplishes an exempt purpose.   See Federation Pharmacy Servs.,

Inc. v. Commissioner, 72 T.C. 687, 691 (1979), affd. 625 F.2d 804

(8th Cir. 1980); est of Hawaii v. Commissioner, 71 T.C. 1067,

1079 (1979), affd. without published opinion 647 F.2d 170 (9th

Cir. 1981); secs. 1.501(c)(3)-1(c)(1) and 1.501(c)(3)-1(e)(1),

Income Tax Regs.

     Whether an organization has a substantial nonexempt purpose

is a question of fact to be resolved on the basis of all the

evidence presented by the administrative record.   See B.S.W.

Group, Inc. v. Commissioner, 70 T.C. 352, 357 (1978); see also

Church by Mail, Inc. v. Commissioner, 765 F.2d 1387, 1390 (9th

Cir. 1985), affg. T.C. Memo. 1984-349; est of Hawaii v.

Commissioner, supra at 1079.   “Factors such as the particular

manner in which an organization’s activities are conducted, the

commercial hue of those activities, and the existence and amount

of annual or accumulated profits are relevant evidence of a

forbidden predominant purpose.”   B.S.W. Group, Inc. v.

Commissioner, supra at 358.

     The burden of proof is on petitioner to demonstrate, based

on materials in the administrative record, that it is operated

exclusively for exempt purposes and that it does not benefit

private interests more than incidentally.   See Rule 217(c)(2)(A);

Church of Scientology v. Commissioner, 823 F.2d at 1317; Florida

Hosp. Trust Fund v. Commissioner, 103 T.C. 140, 146 (1994), affd.
                                - 42 -

71 F.3d 808 (11th Cir. 1996).    For purposes of this proceeding,

we assume that the facts as represented in the administrative

record are true, although in the course of our review we may draw

our own ultimate conclusions and inferences from the facts.    See

American Campaign Academy v. Commissioner, supra at 1063-1064;

Houston Lawyer Referral Serv., Inc. v. Commissioner, 69 T.C. 570,

573-575 (1978).

B.   Promotion of Health as a Charitable Purpose

      Section 501(c)(3) specifies various qualifying exempt

purposes, including “charitable” purposes.   The term “charitable”

is not defined in section 501(c)(3), but is used in its generally

accepted legal sense.   See Nationalist Movement v. Commissioner,

102 T.C. 558 (1994), affd. per curiam 37 F.3d 216 (5th Cir.

1994); sec. 1.501(c)(3)-1(d)(2), Income Tax Regs.   In applying

this standard, courts have looked to the law of charitable

trusts.   See Sound Health Association v. Commissioner, 71 T.C.

158, 177 (1978); see also Bob Jones Univ. v. United States, 461

U.S. 574, 588 n.12 (1983).

      The promotion of health for the benefit of the community is

a charitable purpose.   See Eastern Ky. Welfare Rights Org. v.

Simon, 506 F.2d 1278, 1288-1289 (D.C. Cir. 1974), vacated on

other grounds 426 U.S. 26 (1976); Sound Health Association v.

Commissioner, supra at 177-181; see also 2 Restatement, Trusts

2d, secs. 368, 372 (1959); 4A Scott & Fratcher, Law of Trusts,
                                - 43 -

secs. 368, 372 (4th ed. 1989).    As applied to determinations of

qualification for tax exemption, the definition of the term

“charitable” has not been static.    See Eastern Ky. Welfare Rights

Org. v. Simon, supra at 1287-1290; Sound Health Association v.

Commissioner, supra.   Suffice it to say that, in recognition of

changes in the health-care industry, the standard no longer

requires that “the care of indigent patients be the primary

concern of the charitable hospital, as distinguished from the

care of paying patients”.     Sound Health Association v.

Commissioner, supra at 180.     Rather, the standard reflects "a

policy of insuring that adequate health care services are

actually delivered to those in the community who need them.”       Id.

at 180-181.   Under this standard, health-care providers must meet

a flexible community benefit test based upon a variety of

indicia, one of which may be whether the organization provides

free care to indigents.     Cf. id. at 184-185 (subsidized dues

program was an indicium of charitable purposes).

     To benefit the community, a charity must serve a

sufficiently large and indefinite class; as a corollary to this

rule, private interests must not benefit to any substantial

degree.   See id. at 181.

C.   Proscription Against Benefiting Private Interests

      An organization does not operate exclusively for exempt

purposes if it operates for the benefit of private interests such
                                - 44 -

as designated individuals, the creator or his family,

shareholders of the organization, or persons controlled, directly

or indirectly, by such private interests.   See sec. 1.501(c)(3)-

1(d)(1)(ii), Income Tax Regs.    The private benefit proscription

inheres in the requirement that an organization operate

exclusively for exempt purposes.

     As stated in American Campaign Academy v. Commissioner, 92

T.C. 1053, 1065-1066 (1989):

     When an organization operates 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, the organization
     by definition does not operate exclusively for exempt
     purposes. Prohibited private benefits may include an
     “advantage; profit, fruit; privilege; gain; [or]
     interest.” Occasional economic benefits flowing to
     persons as an incidental consequence of an organization
     pursuing exempt charitable purposes will not generally
     constitute prohibited private benefits. Thus, should
     * * * [the organization] be shown to benefit private
     interests, it will be deemed to further a nonexempt
     purpose under section 1.501(c)(3)-1(d)(1)(ii), Income
     Tax Regs. This nonexempt purpose will prevent [the
     organization] from operating primarily for exempt
     purposes absent a showing that no more than an
     insubstantial part of its activities further the
     private interests or any other nonexempt purposes.
     [Citations and fn. ref. omitted.]

     The proscription against private benefit shares common

elements with, but is distinct from, the proscription against the

inurement of organizational earnings to private shareholders and

individuals, as contained in section 501(c)(3) and sections

1.501(a)-1(c) and 1.501(c)(3)-1(c)(2), Income Tax Regs.   See
                             - 45 -

American Campaign Academy v. Commissioner, supra at 1068.     The

proscription against private benefit encompasses not only

benefits conferred on insiders having a personal and private

interest in the organization, but also benefits conferred on

unrelated or disinterested persons.   See id.; Christian

Stewardship Assistance, Inc. v. Commissioner, 70 T.C. 1037

(1978).

     The mere fact that an organization seeking exemption enters

into a partnership agreement with private parties that receive

returns on their capital investments does not establish that the

organization has impermissibly conferred private benefit.    The

question remains whether the organization has a substantial

nonexempt purpose whereby it serves private interests.     Compare

Plumstead Theatre Socy., Inc. v. Commissioner, 675 F.2d 244 (9th

Cir. 1982), affg. per curiam 74 T.C. 1324 (1980) (a nonprofit

arts organization furthered its charitable purposes by

participating as sole general partner in a partnership with

private parties to produce a play), with Housing Pioneers, Inc.

v. Commissioner, 49 F.3d 1395 (9th Cir. 1995), affg. T.C. Memo.

1993-120 (a nonprofit corporation’s participation as co-general

partner in low-income housing partnerships, structured to trade

off its tax exemption to secure tax benefits for its for-profit

partners, had a substantial nonexempt purpose and impermissibly

served private interests).
                               - 46 -

     The proscription against private benefit corresponds to a

similar proscription in the law of charitable trusts.     “A trust

is not a charitable trust if the property or the income therefrom

is to be devoted to a private use.”     2 Restatement, Trusts 2d,

sec. 376 (1959).    An organization’s property may be impermissibly

devoted to a private use where private interests have control,

directly or indirectly, over its assets, and thereby secure

nonincidental private benefits.

     For instance, in est of Hawaii v. Commissioner, 71 T.C. 1067

(1979), several for-profit ‘est’ organizations that had no formal

structural control over the nonprofit entity in question

nevertheless exerted "considerable control" over its activities.

The for-profit organizations set fees that the nonprofit charged

the public for training sessions, required the nonprofit to carry

on certain types of educational activities, and provided

management personnel paid for and responsible to one of the for-

profits.   Under a licensing agreement with the for-profits, the

nonprofit was allowed to use certain intellectual property for 10

years, and at the end of the licensing agreement, all copyrighted

material, including new material developed by the nonprofit, was

required to be turned over to the for-profits.     The nonprofit was

required to use its excess funds for the development of ‘est’ or

related research.    The for-profits also required that trainers

and local organizations sign an agreement not to compete with
                              - 47 -

‘est’ for 2 years after terminating their relationship with ‘est’

organizations.

     In est of Hawaii v. Commissioner, supra at 1080, this Court

agreed with respondent that the nonprofit was “part of a

franchise system which is operated for private benefit and * * *

its affiliation with this system taints it with a substantial

commercial purpose.”   We found that the “ultimate beneficiaries”

of the nonprofit’s activities were the for-profit corporations,

and that the nonprofit “was simply the instrument to subsidize

the for-profit corporations and not vice versa”.   Id. at 1082.

This Court held that the nonprofit was not operated exclusively

for exempt purposes.   See also Harding Hosp., Inc. v. United

States, 505 F.2d 1068 (6th Cir. 1974) (impermissible private

benefit resulted from a nonprofit hospital's contract with a

physician group, giving them a virtual monopoly over care of the

hospital's patients and the income stream they represented, and

providing the physician group with fees for supervising the

hospital's medical staff); Sonora Community Hosp. v.

Commissioner, 46 T.C. 519 (1966) (impermissible private benefit

resulted from an arrangement whereby a for-profit laboratory was

permitted to occupy space in the nonprofit hospital rent-free,

and paid the hospital’s founding doctors a share of the

laboratory’s gross revenues in consideration of patient referrals

and administrative services), affd. 397 F.2d 814 (9th Cir. 1968).
                              - 48 -

 III.   Petitioner’s Claim to Exemption on a “Stand-Alone” Basis

     Applying the principles described above, we next consider

whether petitioner has established that respondent improperly

denied it tax-exempt status as a section 501(c)(3) organization.

A.   The Relevance of Control--The Parties’ Positions

     Respondent asserts that petitioner has ceded effective

control over its sole activity--participating as a co-general

partner with for-profit parties in the partnerships that own and

operate the Surgery Center--to the for-profit partners and the

for-profit management company that is an affiliate of

petitioner’s co-general partner.   Respondent asserts that this

arrangement is indicative of a substantial nonexempt purpose,

whereby petitioner impermissibly benefits private interests.

     Without conceding that private parties control its

activities, petitioner challenges the premise that the ability to

control its activities determines its purposes.    Petitioner

argues that under the operational test, “the critical issue in

determining whether an organization’s purposes are noncharitable

is not whether a for profit or not for profit entity has control.

Rather, the critical issue is the sort of conduct in which the

organization is actually engaged.”     On brief, the parties agree

that under an aggregate theory of partnership taxation, the

partnerships’ activities are considered petitioner’s own
                               - 49 -

activities.   Petitioner’s brief states:   “The evidence in the

administrative file demonstrates that * * * [the Operating

Partnership] has been operated in an exclusively charitable

manner since 1990".   Therefore, petitioner concludes, it should

be deemed to operate exclusively for charitable purposes.

     We disagree with petitioner’s thesis.    It is patently clear

that the Operating Partnership, whatever charitable benefits it

may produce, is not operated “in an exclusively charitable

manner”.   As stated by Justice Cardozo (then Justice of the New

York Court of Appeals), in describing one of the “ancient

principles” of charitable trusts, “It is only when income may be

applied to the profit of the founders that business has a

beginning and charity an end.”   Butterworth v. Keeler, 219 N.Y.

446, 449-450, 114 N.E. 803, 804 (1916).    The Operating

Partnership's income is, of course, applied to the profit of

petitioner’s co-general partner and the numerous limited

partners.10   It is no answer to say that none of petitioner’s

income from this activity was applied to private interests, for

the activity is indivisible, and no discrete part of the

Operating Partnership's income-producing activities is severable

     10
       In making these observations, we are mindful that it is
the status of petitioner, not of the General Partnership or the
Operating Partnership, that is in issue. Indeed, it is not
meaningful to speak of a partnership’s exempt status, given that
partnerships are nontaxable entities. See sec. 701.
                              - 50 -

from those activities that produce income to be applied to the

other partners’ profit.

     Taken to its logical conclusion, petitioner’s thesis would

suggest that an organization whose main activity is passive

participation in a for-profit health-service enterprise could

thereby be deemed to be operating exclusively for charitable

purposes.   Such a conclusion, however, would be contrary to well-

established principles of charitable trust law.

     Frequently, a business enterprise may have charitable
     effects. * * * A private hospital relieves sickness and
     suffering. * * * However, the primary object of these
     institutions is the pecuniary gain of the operators. Hence
     trusts to aid in the founding or maintenance of private
     hospitals or clinics * * *, which are business enterprises
     operated for the purpose of making profits for stockholders
     or owners, are not charitable even though they involve
     incidentally some public benefits. “It is not charity to
     aid a business enterprise.” [Bogert & Bogert, The Law of
     Trusts and Trustees, sec. 364 (Rev. 2d ed. 1991) (quoting
     Butterworth v. Keeler, 219 N.Y. at 449, 114 N.E. at 804);
     fn. refs. omitted.]

     Clearly, there is something in common between the structure

of petitioner’s sole activity and the nature of petitioner’s

purposes in engaging in it.   An organization’s purposes may be

inferred from its manner of operations; its “activities provide a

useful indicia of the organization’s purpose or purposes.”

Living Faith, Inc. v. Commissioner, 950 F.2d 365, 372 (7th Cir.

1991), affg. T.C. Memo. 1990-484.   The binding commitments that

petitioner has entered into and that govern its participation in

the partnerships are indicative of petitioner’s purposes.    To the
                              - 51 -

extent that petitioner cedes control over its sole activity to

for-profit parties having an independent economic interest in the

same activity and having no obligation to put charitable purposes

ahead of profit-making objectives, petitioner cannot be assured

that the partnerships will in fact be operated in furtherance of

charitable purposes.   In such a circumstance, we are led to the

conclusion that petitioner is not operated exclusively for

charitable purposes.

     Based on the totality of factors described below, we

conclude that petitioner has in fact ceded effective control of

the partnerships’ and the Surgery Center’s activities to for-

profit parties, conferring on them significant private benefits,

and therefore is not operated exclusively for charitable purposes

within the meaning of section 501(c)(3).

B.   Indicia of For-Profit Control Over the Partnerships’
     Activities

     1.   No Charitable Obligation

     Nothing in the General Partnership agreement, or in any of

the other binding commitments relating to the operation of the

Surgery Center, establishes any obligation that charitable

purposes be put ahead of economic objectives in the Surgery

Center’s operations.   The General Partnership agreement does not
                              - 52 -

expressly state any mutually agreed-upon charitable purpose or

objective of the partnership.11

     After the General Partnership acquired its 61-percent

interest, the Operating Partnership--which had long operated as a

successful for-profit enterprise and never held itself out as a

charity--never changed its organizing documents to acknowledge a

charitable purpose.   Indeed, in at least one instance the

Operating Partnership agreement explicitly acknowledges the

partnership’s noncharitable objectives.   Section 16.5.2 of the

Operating Partnership agreement, supra, in authorizing the

General Partnership to amend the Operating Partnership as

necessary to comply with legal requirements, specifies that this

authority may be exercised only if “such amendments do not alter

the economic objectives of the partnership or materially reduce

the economic return to the limited partners.”

     11
       The prefatory “Whereas” clauses to the General
Partnership agreement recite that RHS is entering into the
agreement to “insure the availability of high quality health
services in the most cost effective setting in which such
services can be rendered” and because “the use of an ambulatory
surgical center will contribute to RHS’s goal of providing
comprehensive health care services at an affordable price.” The
partnership agreement, however, does not reflect that this was a
mutual premise. The partnership agreement states as the purpose
of the partnership merely the acquiring of a 61-percent interest
in the Operating Partnership, stating that the General
Partnership “may engage in any and all other activities as may be
necessary, incidental or convenient to carry out the business of
the Partnership as contemplated by this Agreement.”
                               - 53 -

     2.   Petitioner’s Lack of Formal Control

           a.   Managing Directors

     Under the General Partnership agreement, control over all

matters other than medical standards and policies is nominally

divided equally between petitioner and SCA Centers, each

appointing two representatives to serve as managing directors.

(As discussed infra, matters of medical standards and policies

are determined by the Medical Advisory Group, half of whom are

chosen by the General Partnership’s managing directors.)

Consequently, petitioner may exert influence by blocking actions

proposed to be taken by the managing directors, but it cannot

initiate action without the consent of at least one of SCA

Center’s appointees to the managing directors.    For instance,

petitioner lacks sufficient control unilaterally to cause the

Surgery Center to respond to community needs for new health

services, modify the delivery or cost structure of its present

health services to serve the community better, or, as discussed

in more detail infra, terminate SCA Management, if SCA Management

were determined to be managing the Surgery Center in a manner

inconsistent with charitable objectives.

     The administrative record shows that petitioner has

successfully blocked various proposals to expand the scope of

activities performed at the Surgery Center.     Petitioner’s ability

to veto expansion of the scope of the Surgery Center’s
                               - 54 -

activities, however, does not establish that petitioner has

effective control over the manner in which the Surgery Center

conducts activities within its predesignated sphere of

operations.   Nor does it tend to indicate that the Surgery Center

is not operated to maximize profits with regard to those

activities.   Indeed, given that all the partners except

petitioner are for-profit interests not shown to be motivated or

constrained by charitable objectives, and given that all the

limited partners except Beaver Medical Clinic were issued SCA

common stock when the General Partnership acquired its interest

in the Operating Partnership, and given that SCA Management

derives a management fee computed as a percentage of gross

revenues, we find, in the absence of evidence to the contrary,

that a significant profit-making objective is present in the

Surgery Center’s operations.   The high rates of return earned on

the partners’ investments (including petitioner’s) in the

Operating Partnership bolster this finding.

     In sum, the composition of the managing directorship

evidences a lack of majority control by petitioner whereby it

might assure that the Surgery Center is operated for charitable

purposes.12   Consequently, we look to the binding commitments

     12
       The managing directors of the General Partnership are
functionally equivalent to a hospital's board of directors, the
importance of which has been described as follows:

                                                    (continued...)
                               - 55 -

made between petitioner and the other parties to ascertain

whether other specific powers or rights conferred upon petitioner

might mitigate or compensate for its lack of majority control.

          b.    Arbitration Process

     The General Partnership agreement provides for an

arbitration process in the event that the managing directors of

the General Partnership deadlock over a matter other than medical

standards and medical policies, such as approval of new surgical

procedures.    Under these provisions, in the event of a deadlock,

each of the co-general partners selects one arbitrator, and these

two arbitrators select a third.   The arbitrators have final

authority to decide matters referred to them.   The ground rules

for the arbitration process are minimal and provide petitioner no

assurance that charitable objectives will govern the outcome.

Under the General Partnership agreement, the arbitrators are not

required to take into account any charitable or community benefit

     12
      (...continued)
          The board of directors, its composition, and its
     functions are relevant to tax exemption * * * the
     composition of the board provides important evidence that
     the hospital serves public rather than private purposes.
     For example, it is fair to presume that a board of directors
     chosen from the community would place the interests of the
     community above those of either the management or the
     medical staff of the hospital. Thus, the relevance of the
     board is that its process should indicate whether the
     hospital is operated for the benefit of the community or to
     secure benefits for private interests. [Mancino, “Income
     Tax Exemption of the Contemporary Nonprofit Hospital”, 32
     St. Louis U.L.J. 1015, 1051 (1988).]
                                - 56 -

objective, but are simply required to “apply the substantive law

of California”.

     Petitioner asserts that since 1990, neither co-general

partner has invoked the arbitration clause.      The administrative

record is inconclusive on this point.      Even assuming arguendo

that petitioner’s assertion is correct, it merely tends to show

that petitioner and SCA Centers have avoided conflict with regard

to those operating decisions that are subject to arbitration.

Whether such conflicts have been avoided because petitioner’s

purposes and the purposes of its for-profit partner are so

closely aligned, or for some other reason, the administrative

record does not reveal.    Clearly, however, the arbitration

process does not significantly mitigate petitioner’s lack of

majority control to provide any assurance that the General

Partnership will operate to put charitable objectives ahead of

economic objectives.

            c.   The Management Contract

     The management contract between the Operating Partnership

and SCA Management confers broad powers on SCA Management to

enter into contracts, to negotiate with third-party payers and

State and Federal agencies, and to set patient charges for all

services provided, with the exception of charges for physicians’

services.    In short, SCA Management is authorized to manage as it

sees fit many of the day-to-day operations of the Surgery Center,
                               - 57 -

reserving to the Medical Advisory Group of the Operating

Partnership the authority to make all medical decisions.

     Under the management contract, SCA Management is entitled to

receive fees equaling 6 percent of the Operating Partnership’s

gross revenues each month, in addition to reimbursement of its

direct expenses.    This revenue-based compensation structure

provides SCA Management an incentive to manage the Surgery Center

so as to maximize profits.13

     As a practical matter, the Operating Partnership is locked

into the management agreement with SCA Management for at least 15

years.    At its sole discretion, SCA Management may renew the

agreement for two additional 5-year periods on the same terms and

conditions.    The Operating Partnership has the right to terminate

the management contract for breach, but only after the Operating

Partnership has given written notice describing in detail the

     13
       The management contract defines gross revenues as “the
net collectable portion of revenues billed as fees or other
charges arising out of the operation of the [Surgery] Center,
with no deduction for bad debts.” Petitioner suggests on brief
that this means that SCA Management has no disincentive to treat
patients who are unable to pay for treatment, because the “gross
revenues” on which its management fee is based would include the
chargeable amount for the services rendered. We do not find
these arguments convincing. In the first instance, the Surgery
Center does not provide charity care. Moreover, petitioner’s
argument does not address to what extent charitable services, if
they were provided, would give rise to “net collectable * * *
revenues”. Nor does petitioner’s argument address the broader
point that the management contract gives SCA Management an
economic interest to maximize revenues in all aspects of the
Surgery Center’s operations, and not just as relate to charity
care.
                               - 58 -

basis on which it believes termination is justified.    Because the

issuance of such a termination notice would require approval by a

majority of the General Partner’s managing directors, petitioner

could not effect the issuance of such a notice without the

consent of SCA Centers, which is an affiliate of SCA Management.

Thus, even if petitioner determined that SCA Management were

managing the Surgery Center in a manner inconsistent with

charitable purposes, petitioner could not be assured of any

remedy.

     Moreover, neither the General Partnership agreement, the

Operating Partnership agreement, nor the management contract

itself requires that SCA Management be guided by any charitable

or community benefit, goal, policy, or objective.    Rather, the

management contract simply requires SCA Management to render

services as necessary and in the best interest of the Operating

Partnership, “subject to the policies established by [the

Operating Partnership], which policies shall be consistent with

applicable state and Federal law.”

     Petitioner argues that the management contract “was

negotiated at arm’s length, between parties of equal bargaining

strength”.    The administrative record does not support this

contention.   Although the General Partnership agreement was

negotiated between RHS and SCA Centers, it contains only a sparse

description of several key features to be included in the
                               - 59 -

management contract.14   The actual management contract is between

SCA Management and the Operating Partnership, and contains much

more extensive and detailed provisions than are stipulated in the

General Partnership agreement.   Notably, the term of the

management agreement is at variance with the term stipulated in

the General Partnership agreement.15

     The administrative record does not reveal that petitioner or

RHS had any role in negotiating the actual management contract.

It is executed for both the Operating Partnership and SCA

Management by the same individual--David E. Crockett--in his dual

capacities as secretary of SCA Centers and vice president of SCA

Management, raising the suggestion, if not the likelihood, of

self-dealing between these two SCA affiliates.

     Respondent asserts, and we agree, that this long-term

management contract with an affiliate of SCA Centers is a salient

indicator of petitioner's surrender of effective control over the

     14
       The General Partnership agreement merely provides that
SCA Management will assume “full responsibility for administering
the day-to-day operation of the ambulatory center in accordance
with the goals, policies and objectives” of the Operating
Partnership, and stipulates an initial 15-year term, renewable
for two 5-year terms, and a fee equal to 6 percent of the
Operating Partnership’s gross revenues.
     15
       Whereas the General Partnership agreement stipulates a
15-year initial term for the management contract, the actual
management contract modifies this provision to the advantage of
SCA and its affiliates by providing that the initial term is
equal to the term of any indebtedness, lease, or other obligation
of the Operating Partnership guaranteed by SCA or SCA’s
affiliate, but not less than 15 years.
                                - 60 -

Surgery Center’s operations to SCA affiliates, whereby the

affiliates were given the ability and incentive to operate the

Surgery Center so as to maximize profits.    This surrender of

effective control reflects adversely on petitioner's own

charitable purposes in contracting to have its sole activity

managed in this fashion.    Cf. est of Hawaii v. Commissioner, 71

T.C. 1067 (1979).

            d.   Medical Advisory Group

     The Operating Partnership agreement delegates authority for

making decisions about care and treatment of patients and other

medical matters to the Operating Partnership’s Medical Advisory

Group.   This group was inactive before the General Partnership

became involved with the Operating Partnership, but there is no

evidence to show what role, if any, petitioner played in

reconstituting the Medical Advisory Group.

     Only three of the six members of the Medical Advisory Group

are selected by the General Partnership.    The other three are

selected by one of the limited partners, Beaver Medical Clinic.

It is telling that the Medical Advisory Group is composed

entirely of limited partners of the Operating Partnership, all of

whom (except Beaver Medical Clinic) received common stock in SCA

when the General Partnership acquired its Operating Partnership

interest.    Taking all these considerations into account, it is

clear that petitioner lacks sufficient influence to determine the
                                - 61 -

resolution of any matter brought before the Medical Advisory

Group.    Moreover, there is no evidence in the record that the

decisions of the Medical Advisory Committee are subject to

independent review by petitioner or Redlands Hospital.

            e.   Termination of Quality Assurance Activities

     As required by the General Partnership agreement, on April

30, 1990, SCA Management entered into a quality assurance

agreement with RHS.    The term of the quality assurance agreement

was conditioned on maintenance of a specified level of surgery

activity in the Surgery Center.    Petitioner concedes that the

quality assurance agreement terminated after the first year.16

Although the agreement required the parties to negotiate a new

quality assurance agreement in the event of such a termination,

there is no evidence in the record that such negotiations ever

occurred.17

     The termination of the quality assurance agreement vividly

evidences petitioner’s lack of effective control over vital

aspects of the Surgery Center’s operations.    Quality assurance

     16
       The termination of the quality assurance agreement is
disclosed in petitioner's reply brief, filed on May 11, 1998.
Petitioner's counsel represent that the fact of the termination
of the quality assurance agreement was first disclosed to them on
or about Apr. 30, 1998.
     17
       Under the quality assurance agreement, petitioner was
entitled to a fee equal to 1 percent of gross revenues,
commencing in the second year. Because the agreement terminated
after the first year, it appears that petitioner never received
any fees under the agreement.
                              - 62 -

agreements in the health-care industry serve the important dual

functions of attempting to avoid inappropriate services (e.g.,

the wrong services for the patient’s needs, or services that are

improperly rendered), and seeking to assure that enough services

are provided to meet the patient’s needs.    See 2 National Health

Lawyers Association, Health Law Practice Guide, sec. 25.1, at 25-

3 (1997).   The record does not reflect that petitioner performed

any quality assurance work.   Likewise, the record is silent as to

how petitioner, in the absence of any operable quality assurance

agreement, purports to assure itself that these vital functions

will be discharged consistently with charitable objectives.

     3.   Lack of Informal Control

     The administrative record provides no basis for concluding

that, in the absence of formal control, petitioner possesses

significant informal control by which it exercises its influence

with regard to the Surgery Center’s activities.   Nothing in the

administrative record suggests that petitioner commands

allegiance or loyalty of the SCA affiliates or of the limited

partners to cause them to put charitable objectives ahead of

their own economic objectives.   Indeed, until April 1992,

petitioner was in a debtor relationship to SCA.   The limited

partners (except for Beaver Medical Clinic, Inc.) all became

common stockholders of SCA when the General Partnership acquired

its interest in the Operating Partnership.
                              - 63 -

     The administrative record does not establish that petitioner

has the resources or ability effectively to oversee or monitor

the Surgery Center’s operations.   Petitioner has almost no

resources apart from its assets invested in the General

Partnership.   The president of Redlands Hospital also serves as

petitioner’s president and as one of the four managing directors

of the General Partnership.

     On brief, petitioner argues that its influence in the

partnerships is evidenced by various changes that it says

occurred in the operation of the Surgery Center after April 1990,

when the amended Operating Partnership agreement became

effective.   Petitioner suggests that these operational changes

demonstrate that its influence is sufficient to allow it to

achieve its charitable goals through the partnerships' activities

and demonstrate that for-profit interests do not control the

partnerships and the Surgery Center.   As described in more detail

below, the record does not support petitioner’s contentions.

        a. Change in Criteria for Procedures Performed at the
           Surgery Center

     Petitioner asserts that after the General Partnership

acquired its interest in the Operating Partnership, “the decision

to perform a surgery at the Surgery Center was changed from an

economic to exclusively a medical decision.   Accordingly, RHS

achieved its goal of providing complete access to freestanding
                                 - 64 -

ambulatory surgery center care for all members of the Redlands

community irrespective of their ability to pay.”

     This proposed finding of fact is not supported by the

record.   Neither before nor after petitioner’s involvement with

it has the Surgery Center provided charity care.    Moreover, the

administrative record indicates that one aspect of ambulatory

surgery centers that makes them attractive investment

opportunities in the first instance is that they boast favorable

“procedure and payer mixes”.18    Consequently, it is not apparent

from the record to what extent the decision to perform a surgery

at the Surgery Center has ever been an “economic” rather than a

“medical” decision, or exactly how that situation might have

changed after April 1990.

     Even if we assume, arguendo, that a change in criteria did

occur after April 1990, the record does not establish

petitioner’s role in effecting any such change.

     18
       The administrative record includes an investment summary
with respect to SCA and another national health-care provider,
Medical Care International, published by Shearson Lehman
Brothers, dated Aug. 7, 1991. The report states: “To a large
extent the favorable payer mix is a function of the fact that
many procedures safely performed on an outpatient basis happen to
be those with a young patient population.” Similarly, in its
arguments to justify the Surgery Center’s low rate of Medi-Cal
patients, petitioner notes that the Surgery Center does not
perform the types of procedures--emergency room treatments and
obstetrics and gynecology--that typically account for a
"substantial majority" of low-income surgical expenses for a
community.
                              - 65 -

          b.   Provision for Indigent Patients

     Petitioner concedes that as of December 31, 1993, Medi-Cal

patients accounted for only 0.8 percent of total procedures

performed at the Surgery Center.    Petitioner argues that the type

of services which the Service Center offers is not the type of

services typically sought by low-income individuals.    Petitioner

notes that Redlands Hospital has negotiated certain provider

agreements that designate the Surgery Center as a subcontractor

to provide outpatient services for Medi-Cal patients, and that

Redlands Hospital has caused the Surgery Center to increase its

number of managed care contracts.   Petitioner suggests that these

efforts demonstrate petitioner’s influence over the operations of

the Surgery Center and evidence petitioner's charitable purposes.

     We do not find petitioner’s arguments convincing.    The facts

remain that the Surgery Center provides no free care to indigents

and only negligible coverage for Medi-Cal patients.    That low-

income individuals may not typically seek the types of services

the Surgery Center offers may partially explain the virtual

absence of relief it provides for such individuals.    But it

provides no independent basis for establishing petitioner’s

charitable purposes in its involvement with the Surgery Center.

Moreover, the activities of Redlands Hospital in effecting some

negligible degree of Medi-Cal coverage at the Surgery Center and

in increasing the number of managed care contracts do not provide
                               - 66 -

a basis for establishing petitioner's exemption.   Cf. Harding

Hosp., Inc. v. United States, 505 F.2d 1068 (6th Cir. 1974)

(activities performed by third parties did not provide a basis

for organization’s exemption).

     Petitioner asserts that the Surgery Center has no

requirement that patients demonstrate an ability to pay before

receiving treatment.   The record does not reflect whether any

such policy has been communicated to its patients.   Petitioner

suggests that this policy is evidenced by the Surgery Center’s

“substantial Medicare” patronage.   The record shows that Medicare

accounted for 12 percent of invoices at the Surgery Center in the

last half of 1993.   The record does not reflect, however, whether

the Surgery Center waives fees in excess of those covered by

Medicare and accordingly does not establish that ability to pay

is not a factor even for patients covered by Medicare.   Moreover,

the Surgery Center’s treatment of Medicare patients cannot on

this record be attributed to petitioner’s influence over the

Surgery Center’s operations.   According to the affidavit of Mr.

James R. Holmes, who was president of petitioner and Redlands

Hospital at the time of the affidavit, the Surgery Center “has

regularly treated Medicare patients * * * since before 1990.”
                              - 67 -

          c. Coordination of Activities of Redlands Hospital and
             the Surgery Center

     In arguing that it plays an active role in the conduct of

the Surgery Center’s activities, petitioner cites a number of

ways in which Redlands Hospital has integrated its activities

with those of the Surgery Center since the General Partnership

acquired its interest in the Operating Partnership.   These

include Redlands Hospital’s use of the Surgery Center as a site

for training and surgeon proctoring, as well as various other

cooperative training and educational activities between Redlands

Hospital and the Surgery Center.19

     Although there may be cooperation between the Surgery Center

and Redlands Hospital, nothing in the record suggests that these

various cooperative activities are more than incidental to the

for-profit orientation of the Surgery Center’s activities.    Cf.

Harding Hosp., Inc. v. United States, supra at 1075-1076

     19
       The administrative record contains unexplained
inconsistencies regarding certain of these training procedures.
On the one hand, a letter in the administrative record, dated
Nov. 23, 1994, from Ernst & Young to respondent’s representative,
cites laproscopic cholecystectomy (gall bladder surgery) as an
example of a new procedure that Redlands Hospital was extensively
involved in teaching to physicians using the Surgery Center. On
the other hand, an affidavit of Gary J. Cottingham, president of
RHS and Redlands Hospital from Sept. 22, 1987, to May 12, 1995,
states that SCA Centers requested that the Surgery Center begin
to perform outpatient cholecystectomies at the Surgery Center,
but that the General Partnership’s managing directors rejected
the proposal. Mr. Cottingham’s affidavit states: “At least
through May 1995, * * * Outpatient cholecystectomies were not
performed at [the Surgery Center].”
                             - 68 -

(educational, training and community-oriented programs conducted

at a hospital and funded by a third party were not sufficient to

merit the hospital’s tax exemption where other disqualifying

factors were present).

C.   Competitive Restrictions and Market Advantages

     By entering into the General Partnership agreement, RHS

(petitioner's parent corporation and predecessor in interest in

the General Partnership) not only acquired an interest in the

Surgery Center, but also restricted its future ability to provide

outpatient services at Redlands Hospital or elsewhere without the

approval of its for-profit partner.   Paragraph 16 of the General

Partnership agreement, supra, prohibits the co-general partners

and their affiliates from owning, managing, or developing another

freestanding outpatient surgery center within 20 miles of the

Surgery Center, without the other partner’s consent.   Moreover,

Redlands Hospital may not “expand or promote its present

outpatient surgery program within the Hospital.”   In fact,

outpatient surgeries performed at Redlands Hospital decreased

about 17 percent from 1990 to 1995, while those performed at the

Surgery Center increased.

     The General Partnership agreement also restricts the parties

and their affiliates from providing outpatient surgery services

and procedures that the agreement does not specifically authorize

to be provided at the Surgery Center (hereinafter referred to as
                                - 69 -

nonlisted services).    Under this agreement, Redlands Hospital,

but not the co-general partners or any of their other affiliates,

is allowed to perform nonlisted outpatient services that were

currently available to patients in California at the time the

General Partnership agreement was executed.    By contrast, neither

Redlands Hospital nor the co-general partners or their affiliates

are allowed to perform nonlisted outpatient services that first

become available in California during the term of the General

Partnership agreement (i.e., until March 31, 2020), unless the

managing directors of the General Partnership approve.20

     Consequently, RHS effectively restricted its own ability to

assess and service community needs for outpatient services until

the year 2020.    It is difficult to conceive of a significant

charitable purpose that would be furthered by such a restriction.

      The administrative record contains a market research report

on the ambulatory surgery center industry, prepared by Ernst &

Young and transmitted to Redlands Hospital on October 20, 1994.

This report describes the strong movement toward providing health

care services in ambulatory settings, driven both by economic

considerations and technological advances.21    The report notes

     20
       As previously discussed, petitioner lacks sufficient
control to dictate any such approval by the managing directors,
and, in the event of deadlock, the matter would go to
arbitration.
     21
          The report states that during the 1980's, hospital-based
                                                      (continued...)
                                - 70 -

that hospitals face “strong competition” in this market.    It

cites economic advantages that freestanding ambulatory surgery

centers enjoy over hospitals.    These advantages include, among

other things, higher turn-over of operating rooms that increases

the number of “fee-generating procedures” surgeons can do; lower

nurse compensation that in turn leads to “higher margins”; and

the “general tendency for private payers to account for a high

percentage of a surgery center’s mix, since most procedures

performed in outpatient settings are elective (nonemergency) and

are done on younger, non-Medicare patients.”    The report cites

physician relations and capital as two major barriers to entering

this market.

     The Shearson Lehman Brothers investment summary, see supra

note 18, contains similar facts and conclusions.    The report

indicates that SCA and Medical Care International are the two

main surgical center chains, that they are highly profitable, and

that their margins are likely to continue moving higher.    The

report notes that one reason for the high profitability of these

chains is that “they typically shadow-price hospitals, which tend

     21
      (...continued)
outpatient surgeries grew from 3 million in 1980 to 11 million in
1990, and that nonhospital-based surgery volume increased even
faster, experiencing a 21.1-percent growth in procedures between
1989 and 1990 alone. The report projects continued growth in
this industry, stating: “The expansion of ambulatory surgery
service centers is likely to be accelerated by economic
incentives * * * as well as new technological developments.”
                              - 71 -

to charge very high rates for outpatient surgery so they can

shift costs to the private sector and spread out their overhead.”

The report states that “one might expect hospitals to fight hard

for this business by starting up their own FASCs [freestanding

ambulatory surgery centers]”, but that this had not happened to

date because it is very hard for hospitals to do so, due partly

to problems hospitals face in throwing off their own “culture”

and creating an autonomous unit that is small, friendly, and

efficient.   The report states:   “[SCA’s] strategy of developing

three-way joint ventures--consisting of a local hospital,

surgeons, and the company--represents an attractive opportunity

to address these cultural problems.”   The report notes:

     the FASC niche of the health care services industry has the
     further attraction of considerable consolidation
     opportunity. We believe that multispecialty, nonhospital
     FASCs currently number 600-700, with perhaps another 100
     opening each year. Yet there are currently only two chains,
     Medical Care International and [SCA] affiliates, which have
     a total of 109 units. * * *

     Once a surgical group decides to sell its center, there is
     generally only one bidder (Medical Care or [SCA]), with the
     price typically five to seven times pretax income. * * * The
     key issue for MDs is not the modest amount of cash that
     comes from a sale but the operating environment for them
     once the center changes hands.

     In the instant case, the Surgery Center had not one but two

bidders, the General Partnership, offering four to five times

earnings, and another unrelated, for-profit bidder, otherwise

unidentified in the record, offering approximately six times
                               - 72 -

earnings.   A letter from Ernst & Young to respondent’s

representatives, dated July 14, 1992, indicates that the Surgery

Center took the General Partnership’s offer instead of the other,

higher bid because of a desire to have an affiliation with

Redlands Hospital for quality control and other reasons.

     Viewed in its totality, the administrative record is clear

that SCA and petitioner derive mutual economic benefits from the

General Partnership agreement.    By borrowing necessary up-front

capital from SCA, RHS (petitioner's predecessor in interest in

the General Partnership), overcame a capital barrier to gain

entry into a profitable and growing market niche.    By forming a

partnership with RHS, SCA Centers was able to benefit from the

established relationship between Redlands Hospital and the

limited partner physicians to acquire its interest in the Surgery

Center at a bargain price.

     By virtue of this arrangement, petitioner and SCA Centers

realized further mutual benefits by eliminating sources of

potential competition for patients, as is evidenced by the

restrictions on either party’s providing future outpatient

services outside the Surgery Center, and by Redlands Hospital’s

agreeing not to expand or promote its existing outpatient surgery

facility at the hospital.    In light of the statement in the

record that it is typical for national chains such as SCA to

“shadow-price” hospitals in charging for services at outpatient
                              - 73 -

surgery centers, it seems most likely that one purpose and effect

of the containment and contraction of Redlands Hospital’s

outpatient surgery activities is to eliminate a competitive

constraint for setting Surgery Center fees (a matter delegated to

SCA Management under the management contract, excluding charges

for physicians’ services).   Moreover, market consolidation

provided petitioner and SCA Centers mutual advantages by

eliminating pressures to compete in spending for expensive

equipment.22

     There is no per se proscription against a nonprofit

organization's entering into contracts with private parties to

further its charitable purposes on mutually beneficial terms, so

long as the nonprofit organization does not thereby impermissibly

serve private interests.   Cf. Plumstead Theatre Socy. v.

Commissioner, 75 F.2d 244 (9th Cir. 1982); Broadway Theatre

League v. United States, 293 F. Supp. 346 (W.D. Va. 1968).    In

the instant case, however, RHS relied on the established

relationship between Redlands Hospital and Redlands physicians to

enable RHS and SCA affiliates jointly to gain foothold, on

favorable terms, in the Redlands ambulatory surgery market.

Then, by virtue of their effective control over the Surgery

     22
       As stated in a letter in the administrative record
written on behalf of petitioner from Ernst & Young LLP to
respondent, dated Nov. 23, 1994, “The Hospital and * * * [the
Surgery Center] also share surgical equipment so as to avoid a
‘medical arms race’ in the Redlands health care community.”
                              - 74 -

Center, the SCA affiliates have been enabled to operate it as a

profit-making business, with significantly reduced competitive

pressures from Redlands Hospital, and largely unfettered by

charitable objectives that might conflict with purely commercial

objectives.   Cf. est of Hawaii v. Commissioner, 71 T.C. 1067,

1080 (1979); Housing Pioneers, Inc. v. Commissioner, T.C. Memo.

1993-120, affd. 49 F.3d 1395 (9th Cir. 1995).   The net result to

the SCA affiliates is a nonincidental "advantage; profit; fruit;

privilege; gain; [or] interest" that constitutes a prohibited

private benefit.   See American Campaign Academy v. Commissioner,

92 T.C. 1053, 1065 (1989).

D.   Conclusion

     Based on all the facts and circumstances, we hold that

petitioner has not established that it operates exclusively for

exempt purposes within the meaning of section 501(c)(3).   In

reaching this holding, we do not view any one factor as crucial,

but we have considered these factors in their totality:    The lack

of any express or implied obligation of the for-profit interests

involved in petitioner's sole activity to put charitable

objectives ahead of noncharitable objectives; petitioner's lack

of voting control over the General Partnership; petitioner's lack

of other formal or informal control sufficient to ensure

furtherance of charitable purposes; the long-term contract giving

SCA Management control over day-to-day operations as well as a
                              - 75 -

profit-maximizing incentive; and the market advantages and

competitive benefits secured by the SCA affiliates as the result

of this arrangement with petitioner.   Taken in their totality,

these factors compel the conclusion that by ceding effective

control over its operations to for-profit parties, petitioner

impermissibly serves private interests.

           IV.   Petitioner’s Claim to Exemption Under
                    the Integral Part Doctrine

     Petitioner argues that even if it does not qualify for tax

exemption on a “stand alone” basis, it qualifies for exemption

under the integral part doctrine.

     The integral part doctrine is not codified, but rather is

the outgrowth of judicial opinions, rulings, and regulations.

The precise contours of this doctrine are not clearly defined.

The seminal case of Squire v. Students Book Corp., 191 F.2d 1018

(9th Cir. 1951), held that an organization that operated a

bookstore on the premises of a college for the accommodation of

students and faculty was exempt because it bore a “close and

intimate relationship” to the functioning of the college itself.

See also Brundage v. Commissioner, 54 T.C. 1468 (1970); Estate of

Thayer v. Commissioner, 24 T.C. 384 (1955).

     Shortly after the decision in Squire, Treasury regulations

acknowledged the existence of the integral part doctrine in
                              - 76 -

providing an exception to the feeder organization rules under

section 502.23

     Section 1.502-1(b), Income Tax Regs., provides as follows:

        (b) If a subsidiary organization of a tax-exempt
     organization would itself be exempt on the ground that its
     activities are an integral part of the exempt activities of
     the parent organization, its exemption will not be lost
     because, as a matter of accounting between the two
     organizations, the subsidiary derives a profit from its
     dealings with its parent organization, for example, a
     subsidiary organization which is operated for the sole
     purpose of furnishing electric power used by its parent
     organization, a tax-exempt educational organization, in
     carrying on its educational activities. However, the
     subsidiary organization is not exempt from tax if it is
     operated for the primary purpose of carrying on a trade or
     business which would be an unrelated trade or business (that
     is, unrelated to exempt activities) if regularly carried on
     by the parent organization. For example, if a subsidiary
     organization is operated primarily for the purpose of
     furnishing electric power to consumers other than its parent
     organization (and the parent’s tax-exempt subsidiary
     organizations), it is not exempt since such business would
     be an unrelated trade or business if regularly carried on by
     the parent organization. Similarly, if the organization is
     owned by several unrelated exempt organizations, and is
     operated for the purpose of furnishing electric power to
     each of them, it is not exempt since such business would be
     an unrelated trade or business if regularly carried on by
     any one of the tax-exempt organizations. For purposes of
     this paragraph, organizations are related only if they
     consist of--

            (1) A parent organization and one or more of its
          subsidiary organizations; or

     23
       Although these regulations relate expressly to
determining whether an organization is a feeder organization
within the meaning of sec. 502 (an issue that respondent does not
raise in the instant case), this Court previously has referred to
these regulations in applying the integral part doctrine in the
context of sec. 501(c)(3) exemptions. See Geisinger Health Plan
v. Commissioner, 100 T.C. 394, 401 (1993), affd. 30 F.3d 494 (3d
Cir. 1994).
                              - 77 -

          (2) Subsidiary organizations having a common
        parent organization. An exempt organization is not
        related to another exempt organization merely
        because they both engage in the same type of exempt
        activities.

     Since Squire, only a relatively small number of cases have

applied the integral part doctrine.    These cases are fact-

specific.   See Geisinger Health Plan v. Commissioner, 30 F.3d

494, 501 (3d Cir. 1994), affg. 100 T.C. 394 (1993), and cases

cited therein.   As applied in a number of these cases, the

integral part doctrine requires the organization in question to

provide “necessary and indispensable” services solely to an

exempt organization to which it bears some legal or significant

operational relationship.   See, e.g., Hospital Bureau of

Standards & Supplies, Inc. v. United States, 141 Ct. Cl. 91, 158

F. Supp. 560, 562 (1958) (recognizing exemption of an

organization that provided “necessary and indispensable” product

testing and purchasing of hospital supplies for its exempt member

hospital); University Med. Resident Servs., P.C. v. Commissioner,

T.C. Memo. 1996-251 (membership organizations that conducted

clinical training programs for member universities were not

exempt); Council for Bibliographic & Info. Techs. v.

Commissioner, T.C. Memo. 1992-364 (recognizing exemption of an

organization that conducted “necessary and indispensable”

activities for exempt member libraries).    As applied in these

cases, the integral part doctrine operates to recognize a
                              - 78 -

derivative exemption of an organization which serves only another

exempt organization and performs essential services that the

client organization otherwise would have performed for itself to

accomplish its own exempt purposes.    See B.S.W. Group, Inc. v.

Commissioner, 70 T.C. 352, 360 (1978); University Med. Resident

Servs., P.C. v. Commissioner, supra, and cases cited therein.

     Consistent with this rationale, professional group practices

serving exempt entities have been granted tax exemption under the

integral part doctrine.   See University of Mass. Med. Sch. Group

Practice v. Commissioner, 74 T.C. 1299 (1980); B.H.W. Anesthesia

Found., Inc. v. Commissioner, 72 T.C. 681 (1979); University of

Md. Physicians, P.A. v. Commissioner, T.C. Memo. 1981-23.    These

cases involved anesthesiology services or faculty medical

activities that were provided solely to the served hospital or

medical school and that were essential to the operation of the

hospital or medical school.   See Geisinger Health Plan v.

Commissioner, 100 T.C. 394 (1993).

     In Geisinger Health Plan v. Commissioner, supra, this Court

denied a claim for tax exemption asserted by an HMO under the

integral part theory.   We reasoned that the group-practice line

of cases was not controlling because, unlike the exempt

organizations in those cases, the HMO had a population of

subscribers that did not overlap substantially with the patients

of the related exempt entities.   In considering whether the HMO’S
                               - 79 -

activities would have constituted an unrelated business if

conducted by its affiliate, we noted that section 513(a) defines

“unrelated trade or business” by reference to conduct that is

“not substantially related” to the organization’s exempt

functions.    We stated that the determination whether conduct is

“substantially related” in this context “considers the degree to

which income is earned from services rendered or sales made to

persons who are not patients of the exempt affiliated entity.”

Id. at 405.   Noting that entities related to the HMO provided 80

percent of the hospital services rendered to the HMO’s patients,

we held that the record in Geisinger did not justify a conclusion

as to whether the instances in which the HMO’s subscribers were

served by unrelated entities were substantial or insubstantial.

See id. at 406.   Accordingly, we held that the HMO failed to

establish that its activities comprised an integral part of its

affiliate’s exempt activities.

     Similarly, in the instant case, petitioner has failed to

establish that the Surgery Center’s patient population overlaps

substantially with that of Redlands Hospital.    The record does

not reveal what percentage of persons served at the Surgery

Center are patients of Redlands Hospital.   Clearly, however, the

Surgery Center was performing ambulatory surgery on a for-profit

basis for its own patients before petitioner was ever involved

and presumably continued to do so afterward.
                              - 80 -

     Even if we were to assume, arguendo, that the patient

populations of the Surgery Center and Redlands Hospital overlap

substantially, this circumstance would not suffice to confer

exemption on petitioner under the integral part doctrine.    In all

the precedents cited above in which courts have applied the

integral part doctrine to recognize a derivative exemption, the

organization has been under the supervision or control of the

exempt affiliate (or a group of exempt affiliates with common

exempt purposes) or otherwise expressly limited in its purposes

to advancing the interests of the affiliated exempt entity or

entities, and serving no private interests.24   For instance, in

Squire v. Student Book Corp., 191 F.2d 1018, 1019 (9th Cir.

1951), all actions of the bookstore's board of trustees were

submitted to the president of the college for approval, and the

college comptroller acted as ex officio treasurer of the

bookstore.   The bookstore paid no rebates and no part of its

earnings inured to private benefit.    It seems clear that such

considerations are central to the court's holding in Squire that

     24
       In Geisinger Health Plan v. Commissioner, 100 T.C. 394,
402 (1993), affd. 30 F.3d 494 (3d Cir. 1994), we stated that the
parties had agreed that “an organization is entitled to exemption
as an integral part of a tax-exempt affiliate if its activities
are carried out under the supervision or control of an exempt
organization and could be carried out by the exempt organization
without constituting an unrelated trade or business” (emphasis
added). In Geisinger, we made a factual finding that the
affiliated exempt foundation controlled the HMO. See id. at 396.
                              - 81 -

the bookstore's business enterprise “bears a close and intimate

relationship to the functioning of the College itself.”25

     By contrast, as previously discussed, petitioner's sole

activity (the Surgery Center) is effectively controlled by for-

profit parties.   The operations of the Surgery Center plainly are

not dedicated to advancing the interests of petitioner’s exempt

affiliates other than as those interests might happen to coincide

with the commercial interests of petitioner’s for-profit

     25
       See also University of Mass. Med. Sch. Group Practice v.
Commissioner, 74 T.C. 1299 (1980) (organization granted exemption
was created pursuant to a special act of the State legislature as
an integral part of the affiliated medical school and university
hospital); B.H.W. Anesthesia Found., Inc. v. Commissioner, 72
T.C. 681, 683 (1979) (organization granted exemption was the
incorporation of the affiliated hospital's department of
anesthesiology, and most control rested directly or indirectly
with the department's chairman); Brundage v. Commissioner, 54
T.C. 1468 (1970) (public museum that was determined to be an
integral part of the City of San Francisco’s city school system
had previously been conveyed to the city); Estate of Thayer v.
Commissioner, 24 T.C. 384 (1955) (alumni association’s activities
were for the purpose of advancing the affiliated public
university, which held possession of, administered, and invested
the association’s endowment fund, with no moneys used for the
benefit of any alumnus); University Med. Resident Servs., P.C. v.
Commissioner, T.C. Memo. 1996-251 (organizations’ memberships
consisted entirely of nonprofit schools and affiliated teaching
hospitals, representatives of which made all decisions about the
organizations’ activities); Council for Bibliographic & Info.
Techs. v. Commissioner, T.C. Memo. 1992-364 (organization’s
membership consisted entirely of public and academic libraries,
representatives of which comprised the organization’s board of
trustees); University of Md. Physicians, P.A. v. Commissioner,
T.C. Memo. 1981-23 (the organization's articles limited its
activities to serving the interests of the affiliated medical
school and hospital, and petitioner could not be used to serve
any private purpose of its stockholders); Hospital Bureau of
Standards & Supplies, Inc. v. United States, 141 Ct. Cl. 91, 158
F. Supp. 560, 562 (1958) (organization’s membership consisted
entirely of nonprofit hospitals).
                              - 82 -

partners.   Moreover, as previously discussed, petitioner

impermissibly serves private interests.    Petitioner’s activity is

not so substantially and closely related to the exempt purposes

of its affiliates that these private interests may be

disregarded.   See Geisinger Health Plan v. Commissioner, 100 T.C.

at 406, 407.   Accordingly, petitioner is not entitled to

exemption under the integral part doctrine.

     Remaining contentions not addressed herein we deem

irrelevant, without merit, or unnecessary to reach.

     To reflect the foregoing,

                                 Decision will be entered

                           for respondent.
- 83 -