Lawmaker’s Plans Could Make HMO Buyout Costly : Medicine: Rep. Pete Stark’s idea might take a $148-million tax bite out of Health Net management’s proposed purchase of the Woodland Hills-based giant.

As state regulators consider whether to approve Health Net management’s proposal to buy the giant HMO, the controversial deal now faces the threat of a big tax bite if it goes through.

The threat looms because of legislation being considered by Rep. Pete Stark (D-Oakland) in response to public criticism that Health Net’s plan would enable management to gain control of the tax-exempt health maintenance organization for a cheap price, thus cheating the public.

His bill would levy a major excise tax on such HMOs and certain other tax-exempt organizations that convert from nonprofit to for-profit status and are bought by management at prices well below their actual market value.

In Health Net’s case, Stark’s tax could be a stunning $148 million if his idea were approved. “If we have a tax bill this year, I will do everything I can to see it amended” with the proposed change, Stark said in an interview.

Legislators, of course, routinely propose bills that never become law. But there also are indications that the Internal Revenue Service is just offstage in Health Net’s case and could come into play.

The IRS recently revoked the nonprofit status of an unrelated hospital--thus making it liable for corporate income tax--after finding that its management had bought the hospital for an undervalued price and then resold it for a huge profit just two years later.

“I’d be very surprised if the IRS wouldn’t look into this case,” Stark said of Health Net. “There’s some question about whether” the HMO’s executives “are entitled to benefit as they so obviously would.” Stark is a 19-year Congress veteran who is a senior member of the House Ways and Means Committee and chairs its health subcommittee.

Health Net said it is too soon to comment specifically on Stark’s idea or the IRS’ involvement because both are conjecture. But the company asserted in a statement that “we expect no unusual tax impacts” because both Stark’s idea and the IRS ruling assume that the properties are sold for undervalued prices.

Health Net says that won’t happen in its case because the HMO can’t convert until the state Department of Corporations agrees that the price is fair and approves management’s plan. Health Net is the state’s second-largest HMO, with 840,000 members and 1990 revenue of $886 million.

The Department of Corporations’ commissioner, Thomas Sayles, said he’s under no deadline but expects to decide the Health Net matter in four to six weeks.

“We’re taking a hard look at the entire conversion process,” he said. “My job is to make sure fair value is contributed to the success of charity.” Sayles also said the Stark proposal “doesn’t bear on my decision.”

The management of Health Net, led by Chairman Roger F. Greaves, proposes to convert the Woodland Hills-based HMO to for-profit by donating $127 million--its supposed “fair market value” as determined by an outside accounting firm--to a public charity as state law requires.

Nearly all of the cash would come from Health Net’s operations. Simultaneously, Greaves and 30 other Health Net employees would buy the equity ownership of the HMO for a mere $1.5 million.

Consumer groups and several outside suitors that have made higher bids for Health Net claim that the $127 million is way below the HMO’s actual value. They claim that if the deal is approved, the public--which effectively supported the HMO by allowing it to grow under tax-exempt status--would be shortchanged.

Health Net’s management, meanwhile, would stand to earn millions of dollars on its $1.5-million investment if Health Net is later sold or goes public via a stock offering.

Last week, Consumers Union--the nonprofit publisher of Consumer Reports--formally asked Sayles to block the plan and urged him to adopt new rules for HMO conversions that would stop the “looting” of HMOs by “self-dealing” executives.

The new rules should “provide standardized procedures with appropriate public scrutiny and participation” and “protect against the raiding of public assets,” Consumers Union said in its petition to Sayles.

The criticisms caught the attention of Stark. His tax law idea envisions a $148-million tax against Health Net, taking the difference between management’s buyout price ($127 million) and the average of the two highest rival offers ($300 million and $250 million) that Health Net has received from outside bidders.

So far, Health Net’s board--dominated by members of the same management group that wants to buy the HMO--has not welcomed any of the outside offers.

In a recent letter to IRS Commissioner Fred T. Goldberg, Stark said that the Health Net case appeared to be “a terrible abuse of tax-exempt status” and that his proposed tax “would prevent violations of the public trust in cases such as this.”

Goldberg has not yet responded to Stark’s letter, the IRS said, and so it declined comment. However, Stark’s staff did hold “meaningful discussions” with Health Net executives last week in which the HMO further explained its case, Health Net spokesman Jim Lucas said.

The IRS’ potential involvement stems from a “private letter ruling” that it issued against a nonprofit hospital. The IRS found that the hospital had been bought by its management for $6.3 million in 1983, then resold for $29.6 million only two years later.

The IRS ruled that management first bought the hospital “for less than fair market value.” So the IRS revoked the nonprofit status retroactively to 1983, effectively making proceeds of management’s sale of the facility subject to corporate tax.

(The IRS did not disclose the hospital’s name, but the trade magazine Modern Healthcare recently identified it as The Manor, a psychiatric hospital in Tarpon Springs, Fla.)

A private letter ruling “by definition does not have applicability” to anyone other than the party involved, and hence its name, IRS spokesman Don Roberts said. “It may not be cited as precedent.”

But that doesn’t exclude the possibility that a specific ruling could be made in Health Net’s case if the IRS found it necessary, and the facts in the Florida case “seem very similar to the facts” concerning Health Net’s proposed conversion, Stark said in his letter to Goldberg.

Health Net’s Lucas said Stark’s tax idea is flawed because it takes into account the outside takeover bids.

“The premise of Stark’s statement is that there is an auction” taking place for Health Net, when in fact “California law does not contemplate an auction in these sorts of situations,” Lucas said.

Indeed, the Department of Corporations agrees that outside offers are irrelevant to whether it approves HMO conversions to for-profit status. The agency says it has no authority to urge an HMO’s board to accept one offer over another.

Health Net first applied for its conversion in March, but did not publicly announce it. After press reports about the plan surfaced in May, the outside suitors emerged.

The bidders include Humana Inc., a hospital operator based in Louisville, Ky.; Qual-Med Inc., a Colorado-based HMO operator, and Blue Cross of California in Woodland Hills, which has proposed a non-cash merger of Health Net with its CaliforniaCare HMO unit.