Dr. Prem Reddy, a cardiologist, is the founder and chairman of Prime Healthcare Services. He is also president of the Dr. Prem Reddy Family Foundation and Prime Healthcare Services Foundation. Credit: Ana Venegas/The Orange County Register

A foundation controlled by Dr. Prem Reddy, the driving force behind Southern California’s fast-growing Prime Healthcare Services hospital chain, may have avoided hundreds of thousands of dollars in federal taxes through a questionable charitable gift, tax experts said.

Public records show that in 2009, a $1 million charitable donation made by Reddy’s family foundation wound up in the coffers of the Prime Healthcare Services Foundation, another nonprofit controlled by Reddy that owns two of the chain’s 14 hospitals and is trying to buy a third.

Federal law requires private foundations to donate a minimum percentage of their assets to approved charities or face hefty taxes, and the family foundation didn’t appear to have met that requirement, according to three tax experts who reviewed the filings for California Watch. The tax bill is potentially $217,000.

The foundation’s tax returns for 2009, the most recent ones made public, don’t reflect payment of these taxes.

One expert said the unusual transactions might have been subject to an additional IRS tax that applies to bequests from one private foundation to another. That tax liability would be an additional $210,000.

“Things have not all been done as things should be,” said Aaron Dorfman, executive director for the National Committee for Responsive Philanthropy in Washington, D.C.

Michael Sarrao, general counsel for Prime Healthcare and secretary and treasurer of the Prime Healthcare Services Foundation, wrote in an e-mail that the transactions at issue were “in full compliance with all applicable laws.”

He declined to respond to specific questions, accusing California Watch of seeking “to misrepresent facts to create (a) story when none exists.”

Reddy, Prime’s founder and chairman, is a “dedicated philanthropist,” his website says. He grew up in an Indian village without electricity, according to published accounts, and became a multimillionaire health care entrepreneur after coming to the United States in the 1970s to complete his medical training.

Prime Healthcare includes 13 hospitals in Southern California and one in Shasta County. Of those, the Prime Healthcare Services Foundation owns the two nonprofit hospitals, Encino Hospital Medical Center and Montclair Hospital Medical Center.

Prime is known for buying money-losing hospitals and turning them around through aggressive cost cutting and billing practices. The state attorney general is conducting a hearing tomorrow in Victorville on whether the foundation should be allowed to buy the bankrupt Victor Valley Community Hospital in San Bernardino County.

The financial transactions questioned by experts involve the Dr. Prem Reddy Family Foundation. Reddy established the tax-exempt private foundation in 1986 “to provide and support healthcare education” in Southern California, records show. Reddy is president, and his two daughters are the other officers.

Reddy has made big donations to the foundation. In 2008, according to tax returns, he donated $15 million. A real estate partnership in which he is involved donated land in San Bernardino County valued at $7.3 million.

In 2008, the foundation reported that it funded $131,000 in college scholarships and donated $78,000 to a variety of causes, including the Rotary Club, American Heart Association and a now-defunct museum devoted to 1950s cowboy actor Roy Rogers.

On Dec. 29, 2008, the family foundation made its biggest bequest of the year – a $1.05 million grant to the American Telugu Association, an Illinois-based charity established to benefit members of south India’s Telugu ethnic group. Reddy, who was born in south India, was on the association’s board of directors.

At the time that Reddy’s foundation gave the money, the Telugu association had financial problems. Its gala U.S. convention, held in New Jersey the previous fall, had run hundreds of thousands of dollars over budget, records show. After Reddy’s foundation donated the $1.05 million, the Telugu association’s board personally thanked Reddy for his “contribution to cover the deficit,” meeting minutes show.

Within a few months, the organization’s financial problems led to conflict. According to an account in the newspaper India Abroad, 13 of the association’s 27 directors quit to form a new organization. Reddy joined the breakaway group, and when he left, he asked for a refund of his donation.

On April 18, 2009, the American Telugu Association subtracted a “handling fee” of $10,500 and “returned the funds … to an entity related to the donor,” according to its financial statement.

But the money was not returned to the Reddy Family Foundation.

Instead, it went to the Prime Healthcare Services Foundation, which operates nonprofit hospitals in the Prime chain. Reddy, the founder, is its president. The other officer is Sarrao, the company attorney.

On its 2009 tax return, the health care foundation reported a contribution of $1.0395 million from the American Telugu Association. A spokesman for the Telugu association said the payment was a refund, not a contribution as reported on the health care foundation statements. The check was written to the Prime Healthcare Services Foundation because that’s what Reddy requested, he said.

Refund treated as charitable contribution

Treating a refund to the family foundation as a contribution to the health care foundation creates tax issues, according to the tax experts consulted by California Watch.

By law, foundations each year are required to donate funds equal to 5 percent of their total holdings to appropriate donors. If they don’t, foundations must pay a 30 percent tax on the amount they should have given away.

In 2008, according to its tax return, the Reddy Family Foundation was required to donate $1.004 million to meet the 5 percent threshold. The foundation reported that it donated $1.26 million, including the bequest to the Telugu association.

Backing out the refunded $1.05 million, the family foundation fell short of its required donations by almost $724,000. At a tax rate of 30 percent, the foundation would have had to pay the IRS $217,000, but no payment is reflected in its tax returns, according to documents.

Seth Feldman, a consultant on nonprofit issues, said the bequest to the Telugu association shouldn’t count. “The problem is, when he had his falling out with the organization, it wasn’t a gift, because they refunded it,” he said.

The fact that the refunded money wound up with another private foundation doesn’t resolve the tax issues. Instead, it raises an additional tax concern, said

Tyree Collier, a lawyer at the Dallas firm Thompson & Knight, where he represents nonprofit organizations.

Collier said that in most circumstances, the IRS regards a grant from one private foundation to another private foundation as a taxable expenditure. Such donations are subject to a 20 percent tax.

In an interview, Collier said the IRS likely would apply that rationale to the chain of transactions.

“The money was returned to the family foundation, and the family foundation made a grant to the health care foundation,” he said. “I think the IRS would be likely to analyze it that way.”

By that analysis, the family foundation would owe an additional $210,000 in taxes, but the tax returns don’t show payment of that tax, either.

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Lance Williams is a former senior reporter for Reveal, focusing on money and politics. He has twice won journalism’s George Polk Award – for medical reporting while at The Center for Investigative Reporting, and for coverage of the BALCO sports steroid scandal while at the San Francisco Chronicle. With partner Mark Fainaru-Wada, Williams wrote the national bestseller “Game of Shadows: Barry Bonds, BALCO, and the Steroids Scandal that Rocked Professional Sports.” In 2006, the reporting duo was held in contempt of court and threatened with 18 months in federal prison for refusing to testify about their confidential sources on the BALCO investigation. The subpoenas were later withdrawn. Williams’ reporting also has been honored with the White House Correspondents’ Association’s Edgar A. Poe Award; the Gerald Loeb Award for financial reporting; and the Scripps Howard Foundation’s Award for Distinguished Service to the First Amendment. He graduated from Brown University and UC Berkeley. He also worked at the San Francisco Examiner, the Oakland Tribune and the Daily Review in Hayward, California.