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Carle Foundation v. United States

decided: November 29, 1979.


Appeal from the United States District Court for the Eastern District of Illinois, Danville Division. No. 75 C 2148 -- Henry S. Wise, Judge.

Before Fairchild, Chief Judge, and Swygert and Sprecher, Circuit Judges.

Author: Sprecher

The question raised in this appeal is whether the sales by a tax-exempt hospital pharmacy to a nonexempt clinic and to the clinic's private patients give rise to unrelated business taxable income. We hold that they do and therefore reverse the judgment of the lower court.


The Carle Foundation, which is composed of the Carle Foundation Hospital and the Carle Foundation Pharmacy, has been exempt from federal income taxes since 1949 under 26 U.S.C. § 501(c)(3) and its predecessor statute. The Foundation rents out office space within its complex to the Carle Clinic Association, a private enterprise run by doctors who engage in the practice of medicine on a for-profit basis. The Clinic has never been, nor has it requested to be, a tax-exempt organization.

With the exception of a small courtesy staff, the Foundation Hospital is staffed entirely by doctors from the Clinic. The doctors are not employees of the Hospital; they are employees of the Clinic, where they pursue private practice. In addition to the identity of medical staff, the proximity of the Hospital and Clinic results in their also sharing some physical facilities, equipment and services. For example the medical records for all patients in the complex are kept by Hospital personnel and are centrally located in the Clinic area of the compound. Moreover, Clinic facilities are used for laboratory testing, radiological services, electrocardiograms, electroencephalograms and radioisotope testing for patients of the Hospital as well as for private patients of the Clinic. Since their doctors are affiliated with the Foundation Hospital, Clinic patients who require hospitalization are admitted to that hospital. Yet, despite these shared facilities and services, the Clinic and Hospital are distinct legal entities.

The Hospital Pharmacy, part of the tax-exempt Foundation, supplies pharmaceuticals to the Hospital as well as to the Clinic and to some of the Clinic's private patients.*fn1 Because of these sales to other than the Hospital and its patients, the Internal Revenue Service assessed against the Foundation a $67,266.51 deficiency for the tax years 1971 and 1972. The Foundation paid the assessment and instituted this refund action. The lower court granted the refund with respect to the sale proceeds from the Clinic and its patients, holding that those sales were substantially related to the tax exempt purpose of the Foundation and therefore did not generate unrelated business taxable income. The Government appealed.


The Government argues that the sale of pharmaceuticals to the Clinic and its private patients constitutes an unrelated trade or business and is therefore taxable under sections 511-13 of the Internal Revenue Code of 1954, 26 U.S.C. §§ 511-13. In essence, those sections provide that an organization shall be taxed on income from a regularly operated trade or business which is unrelated to its tax-exempt purpose. There is no dispute that the Pharmacy conducts a trade or business; rather, the Government argues that these sales by the Pharmacy are "unrelated."

Section 513(a) defines "unrelated trade or business," in pertinent part, as:

Any trade or business the conduct of which is not Substantially related . . . to the exercise or performance by such organization of its . . . purpose or function constituting the basis for its exemption under section 501 . . . except that such term does not include any trade or business

(2) which is carried on, in the case of an organization described in section 501(c)(3) . . . by the organization primarily for the convenience of its . . . patients . . . .

26 U.S.C. § 513(a) (emphasis added).

We will first address the finding by the lower court "that prescription sales to Clinic outpatients and wholesale (drug sales) to the Clinic . . . have been amply demonstrated to be carried out primarily for the convenience of (the Foundation's) patients," within the meaning of section 513(a)(2). App. 255.*fn2 Although the lower court alluded to the 1968 Revenue Rulings which dealt with the conditions under which pharmaceutical sales by an exempt hospital will constitute unrelated business income, it did not address itself specifically to an analysis of Rev.Rul. 68-376, 1968-2 C.B. 246, which gives examples of "patients" within the meaning of section 513(a)(2). Since revenue rulings are to be given weight by the courts, McMartin Industries, Inc. v. Vinal, 441 F.2d 1274, 1275-76 (8th Cir. 1971), we must closely analyze the ruling.

The Service listed six examples of relationships that determine whether a person is a "patient": (1) a person admitted to a hospital as an inpatient; (2) a person receiving general or emergency diagnostic, therapeutic, or preventive health services from outpatient facilities of a hospital; (3) a person directly referred to the hospital's outpatient facilities by his private physician for specific diagnostic or treatment procedures; (4) a person refilling a prescription written during the course of his treatment as a patient of the hospital; (5) a person receiving medical services as part of a hospital administered home care program; and (6) a person receiving medical care and services in a hospital affiliated ...

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