Tax-exempt hospitals (each a “hospital” and, collectively, “hospitals”), and their affiliated tax-exempt faculty or physician practices if applicable, may face concern about retaining their tax-exempt status in the face of the Patient Protection and Affordable Care Act and other changes to tax-exemption requirements. This article provides background, considerations and recommendations for a hospital to consider in maintaining its tax-exempt status, including the following core suggestions:
Hospitals, as a starting point to assess community benefit, should be aware that case law, particularly state case law, suggests that if the value of charitable services provided each year is 1 percent or less of gross revenues, then the amount of community benefit is not adequate. [1] Under federal law, no specific percentage has been mandated. An IRS study recently found that of the hospitals it surveyed, on average, approximately 9 percent of revenue was spent on community benefit. Twenty percent of hospitals surveyed reported total community benefit spending of less than 2 percent of revenue. In addition, nearly 60 percent of the hospitals surveyed provided less than or equal to 5 percent of revenue on uncompensated care. Similarly, a 2006 Congressional Budget Office report found that non-profit hospitals devoted approximately 5 percent of total revenues to uncompensated care. Thus, it appears that dedicating 3-7 percent of revenue on a variety of community benefit and charity care activities is likely adequate.
Hospitals may also consider that courts have found that if (i) only a very small number of patients are provided free or discounted care, (ii) the dollar value of free care that is provided is minimal, (iii) unpaid bills are immediately referred to collections, (iv) uninsured patients are charged the healthcare entity’s full rates, (v) the healthcare entity fails to publicize its Medicare and Medicaid services and indigent patient policies, (vi) the healthcare entity fails to provide apparent benefits to the immediate community it serves, (vii) the healthcare entity does not allocate surplus revenue to research, education and medical training and (viii) the healthcare entity does not promote health for the benefit of its community, the healthcare entity may not be entitled to a tax-exemption [2]. In addition if applicable, then the hospital should ensure that it retains sufficient control over the its related physician practice and its physicians to ensure that the hospital is providing a community benefit throughout the organization.
The remainder of this article addresses the following issues: (i) general tax-exemption key requirements, (ii) new tax-exemption requirements established under PPACA, (iii) potential tax-exemption issues for accountable care organizations, (iv) the IRS’s audit focus, (v) hospital operations recommendations and (vi) internal audit considerations.
1. Tax-exemption key requirements. A key to maintaining the tax-exempt status of a hospital is to continually act in furtherance of its community and charitable purpose and to provide community benefits [3]. If a hospital fails to do so, it risks losing its tax-exempt status. While the IRS does not specifically define “community benefit,” PPACA established new requirements for certain healthcare entities to maintain their tax-exempt status, as discussed in Section 2 below, which likely may be considered some evidence of community benefit. Other examples of community benefit include providing charitable care, offering health programs to the public, educating health professionals, and conducting medical research. A hospital does not have to engage in all of these activities, but it must provide enough community benefit to provide the IRS with evidence that the hospital is acting consistently with its charitable purpose. Hospitals will also soon have to begin providing evidence to the IRS of the community benefits that they provide on Schedule H of the Form 990.
There are also three other core areas of exposure for tax-exempt entities, like hospitals, including: excess benefit transactions, private inurement and unrelated business income taxes. According to the IRS, an “excess benefit transaction” is one in which “an economic benefit is provided by an applicable tax-exempt organization, directly or indirectly, to or for the use of a disqualified person, and the value of the economic benefit provided by the organization exceeds the value of the consideration received by the organization.”
Similarly, “private inurement” occurs when an individual with significant authority in the organization enters into a transaction or arrangement with the organization in which the individual receives excessive, disproportionate benefits.
Finally, according to the IRS, a tax-exempt organization engages in “unrelated business income” if it participates in an activity that “is a trade or business, it is regularly carried on, and it is not substantially related to furthering the exempt purpose of the organization.” Tax-exempt entities generally must pay taxes on unrelated business income.
Hospitals must first be aware of potential excess benefit transactions resulting from, for example, excessive compensation arrangements and non-fair-market-value transactions with certain disqualified persons. [4] Disqualified persons may include physicians, medical directors, officers of the hospital or of the affiliated tax-exempt physician practice, and the board of directors of the hospital or of the affiliated tax-exempt physician practice. Avoiding the provision of excessive compensation or benefits is a core concern in the acquisition and operation of tax-exempt physician practices. Individuals, such as members of the board of directors, may have to pay penalties in the form of excise taxes for engaging in such excess benefit transactions. Examples of excess benefit transactions include:
2. New PPACA requirements. PPACA imposes certain new requirements upon tax-exempt, non-profit hospitals in order to maintain their tax-exempt status. These new requirements include:
To implement the new requirements, which are contained in Section 501(r) of the Code, the IRS drafted new annual reporting requirements that certain tax-exempt healthcare entities must complete. Such requirements are set forth in Form 990, Schedule H. In essence, these tax-exempt healthcare entities must show the IRS they are providing a community benefit.
3. Tax-exempt requirements for ACOs. PPACA also established ACOs, which are intended to provide quality healthcare for Medicare beneficiaries and allow the ACO participants to share in the savings from managing care more efficiently. On March 31, 2011, the IRS issued guidance and solicited comments regarding tax-exempt entities’ participation in ACOs. The ACO-related tax issues include whether ACOs will themselves be tax-exempt and, if not, how organizations that participate in ACOs will be treated for tax purposes. The IRS intends to look through the ACO and attribute the ACO’s commercial activities to the tax-exempt hospital if such arrangements violate tax-exempt purposes. Also, the IRS intends to look at whether the participating tax-exempt hospital has a sufficient level of control over the ACO’s activities such that the ACO will serve the hospital’s charitable purposes.
4. IRS audit focus. Since all of the healthcare operations of a tax-exempt entity must meet the new PPACA tax-exemption requirements, the IRS has indicated that it may audit the following tax-exempt entity operations:
Failure of an individual hospital or owned physician practice, which is part of a hospital system, to meet the PPACA tax-exemption requirements could affect the tax-exempt status of the entire hospital system. In turn, this could affect the taxability of income from facility-financed, tax-exempt bonds for private use, pension benefits and other government contracts and research grants.
5. Practice operations recommendations. A hospital must ensure that income generated through its affiliated tax-exempt physician practice employees is also tax-exempt and is not derived from any unrelated trade or business income. Thus, in addition to generally providing a community benefit and meeting certain other IRS requirements, a hospital should:
As noted previously, hospitals may also consider that courts have found that if (i) only a very small number of patients are provided free or discounted care, (ii) the dollar value of free care that is provided is minimal, (iii) unpaid bills are immediately referred to collections, (iv) uninsured patients are charged the health care entity’s full rates, (v) the healthcare entity fails to publicize its Medicare and Medicaid services and indigent patient policies, (vi) the healthcare entity fails to provide apparent benefits to the immediate community it serves, (vii) the healthcare entity does not allocate surplus revenue to research, education and medical training and (viii) the healthcare entity does not promote health for the benefit of its community, then the healthcare entity may not be entitled to a tax-exemption [6].
6. Internal audit considerations. A hospital should consider participating in an internal audit of its operations to determine if there are any practices that could negatively affect its tax-exempt status. Generally, in an internal audit, the auditors would review compensation agreements, contracts, information regarding disqualified parties and any information or reports regarding community benefits. A hospital should also be prepared to answer the more specific questions below:
If a hospital cannot adequately or appropriately respond to the questions above, it should implement changes to ensure that its tax-exempt status is protected.
- Take steps to develop a rebuttable presumption that all compensation relationships are reasonable;
- Follow the tax-exemption requirements imposed by PPACA, now codified at Section 501(r) of the Internal Revenue Code (discussed in Section 2 below);
- Provide, document and review the charitable benefits and charity care the hospital provides to the community on an annual basis;
- Publicize the hospital’s willingness to accept Medicare and Medicaid patients and its services available to indigent patients; and
- Ensure that any money allocated for community benefit purposes is utilized for activities that actually provide a community benefit, such as research or education of health professionals. The hospital should likely, however, do more than simply allocate certain funds to assure that it can defend that it properly serves community purposes.
Hospitals, as a starting point to assess community benefit, should be aware that case law, particularly state case law, suggests that if the value of charitable services provided each year is 1 percent or less of gross revenues, then the amount of community benefit is not adequate. [1] Under federal law, no specific percentage has been mandated. An IRS study recently found that of the hospitals it surveyed, on average, approximately 9 percent of revenue was spent on community benefit. Twenty percent of hospitals surveyed reported total community benefit spending of less than 2 percent of revenue. In addition, nearly 60 percent of the hospitals surveyed provided less than or equal to 5 percent of revenue on uncompensated care. Similarly, a 2006 Congressional Budget Office report found that non-profit hospitals devoted approximately 5 percent of total revenues to uncompensated care. Thus, it appears that dedicating 3-7 percent of revenue on a variety of community benefit and charity care activities is likely adequate.
Hospitals may also consider that courts have found that if (i) only a very small number of patients are provided free or discounted care, (ii) the dollar value of free care that is provided is minimal, (iii) unpaid bills are immediately referred to collections, (iv) uninsured patients are charged the healthcare entity’s full rates, (v) the healthcare entity fails to publicize its Medicare and Medicaid services and indigent patient policies, (vi) the healthcare entity fails to provide apparent benefits to the immediate community it serves, (vii) the healthcare entity does not allocate surplus revenue to research, education and medical training and (viii) the healthcare entity does not promote health for the benefit of its community, the healthcare entity may not be entitled to a tax-exemption [2]. In addition if applicable, then the hospital should ensure that it retains sufficient control over the its related physician practice and its physicians to ensure that the hospital is providing a community benefit throughout the organization.
The remainder of this article addresses the following issues: (i) general tax-exemption key requirements, (ii) new tax-exemption requirements established under PPACA, (iii) potential tax-exemption issues for accountable care organizations, (iv) the IRS’s audit focus, (v) hospital operations recommendations and (vi) internal audit considerations.
1. Tax-exemption key requirements. A key to maintaining the tax-exempt status of a hospital is to continually act in furtherance of its community and charitable purpose and to provide community benefits [3]. If a hospital fails to do so, it risks losing its tax-exempt status. While the IRS does not specifically define “community benefit,” PPACA established new requirements for certain healthcare entities to maintain their tax-exempt status, as discussed in Section 2 below, which likely may be considered some evidence of community benefit. Other examples of community benefit include providing charitable care, offering health programs to the public, educating health professionals, and conducting medical research. A hospital does not have to engage in all of these activities, but it must provide enough community benefit to provide the IRS with evidence that the hospital is acting consistently with its charitable purpose. Hospitals will also soon have to begin providing evidence to the IRS of the community benefits that they provide on Schedule H of the Form 990.
There are also three other core areas of exposure for tax-exempt entities, like hospitals, including: excess benefit transactions, private inurement and unrelated business income taxes. According to the IRS, an “excess benefit transaction” is one in which “an economic benefit is provided by an applicable tax-exempt organization, directly or indirectly, to or for the use of a disqualified person, and the value of the economic benefit provided by the organization exceeds the value of the consideration received by the organization.”
Similarly, “private inurement” occurs when an individual with significant authority in the organization enters into a transaction or arrangement with the organization in which the individual receives excessive, disproportionate benefits.
Finally, according to the IRS, a tax-exempt organization engages in “unrelated business income” if it participates in an activity that “is a trade or business, it is regularly carried on, and it is not substantially related to furthering the exempt purpose of the organization.” Tax-exempt entities generally must pay taxes on unrelated business income.
Hospitals must first be aware of potential excess benefit transactions resulting from, for example, excessive compensation arrangements and non-fair-market-value transactions with certain disqualified persons. [4] Disqualified persons may include physicians, medical directors, officers of the hospital or of the affiliated tax-exempt physician practice, and the board of directors of the hospital or of the affiliated tax-exempt physician practice. Avoiding the provision of excessive compensation or benefits is a core concern in the acquisition and operation of tax-exempt physician practices. Individuals, such as members of the board of directors, may have to pay penalties in the form of excise taxes for engaging in such excess benefit transactions. Examples of excess benefit transactions include:
- Making payments in excess of fair market value for goods and services, such as employment compensation or vendor contracts;
- Providing discounted office space;
- Providing free or discounted billing services; or
- Providing excessive payments for administrative services.
2. New PPACA requirements. PPACA imposes certain new requirements upon tax-exempt, non-profit hospitals in order to maintain their tax-exempt status. These new requirements include:
- Having written, qualified financial assistance and emergency medical care policies publicized and made available to the public;
- Avoiding certain abusive billing and collection practices;
- Limiting charges to individuals eligible for financial assistance; and
- Providing a community health needs assessment report to the IRS for tax years beginning after March 23, 2012.
To implement the new requirements, which are contained in Section 501(r) of the Code, the IRS drafted new annual reporting requirements that certain tax-exempt healthcare entities must complete. Such requirements are set forth in Form 990, Schedule H. In essence, these tax-exempt healthcare entities must show the IRS they are providing a community benefit.
3. Tax-exempt requirements for ACOs. PPACA also established ACOs, which are intended to provide quality healthcare for Medicare beneficiaries and allow the ACO participants to share in the savings from managing care more efficiently. On March 31, 2011, the IRS issued guidance and solicited comments regarding tax-exempt entities’ participation in ACOs. The ACO-related tax issues include whether ACOs will themselves be tax-exempt and, if not, how organizations that participate in ACOs will be treated for tax purposes. The IRS intends to look through the ACO and attribute the ACO’s commercial activities to the tax-exempt hospital if such arrangements violate tax-exempt purposes. Also, the IRS intends to look at whether the participating tax-exempt hospital has a sufficient level of control over the ACO’s activities such that the ACO will serve the hospital’s charitable purposes.
4. IRS audit focus. Since all of the healthcare operations of a tax-exempt entity must meet the new PPACA tax-exemption requirements, the IRS has indicated that it may audit the following tax-exempt entity operations:
- Hospital facilities that were operated by the hospital system any time during the taxable year that are licensed, registered or similarly recognized as a hospital under state law, whose principal function or purpose is hospital care without regard to Section 501(r) of the Code (the new PPACA tax-exemption requirements). This information, which is reported on Schedule H of Form 990, may provide additional audit leads for the IRS.
- Non-hospital healthcare facilities operated during the tax year, regardless of whether they are registered under state law. These could include subsidiaries and joint venture operations with physician practices that may lead to further IRS review for unrelated business income and excess benefits.
Failure of an individual hospital or owned physician practice, which is part of a hospital system, to meet the PPACA tax-exemption requirements could affect the tax-exempt status of the entire hospital system. In turn, this could affect the taxability of income from facility-financed, tax-exempt bonds for private use, pension benefits and other government contracts and research grants.
5. Practice operations recommendations. A hospital must ensure that income generated through its affiliated tax-exempt physician practice employees is also tax-exempt and is not derived from any unrelated trade or business income. Thus, in addition to generally providing a community benefit and meeting certain other IRS requirements, a hospital should:
- Publicize its acceptance of Medicare and Medicaid patients and its indigent services to the general public [5];
- Consider other ways that the hospital can provide a community benefit, including allocating money to research and development, measuring how much care is provided to Medicare and Medicaid patients and fulfilling the new PPACA tax-exemption requirements discussed in Section 2;
- Review physician leadership and governance practices on issues including insurance, office space, record-keeping, retirement and health benefits;
- Review fair market value considerations for practice acquisitions and physician compensation with the board of directors, as well as obtain independent assessments of compensation and asset purchase prices;
- Consider and fulfill the compensation practice questions in accordance with Section 6 below; and
- Consider including a provision in the practice physician contracts that requires the practice physicians to act consistently with the charitable purpose of the hospital and consider including language stating that the practice physicians will not discriminate against any patient based upon payor type, including Medicare, Medicaid and self-pay. If many of the practice physicians do not serve Medicare and Medicaid patients, the hospital may consider, assuming it has some significant level of such patients, allocating physician efforts to serving Medicare, Medicaid and indigent patients. Further, a hospital policy may state that physicians shall not discriminate based upon payor.
As noted previously, hospitals may also consider that courts have found that if (i) only a very small number of patients are provided free or discounted care, (ii) the dollar value of free care that is provided is minimal, (iii) unpaid bills are immediately referred to collections, (iv) uninsured patients are charged the health care entity’s full rates, (v) the healthcare entity fails to publicize its Medicare and Medicaid services and indigent patient policies, (vi) the healthcare entity fails to provide apparent benefits to the immediate community it serves, (vii) the healthcare entity does not allocate surplus revenue to research, education and medical training and (viii) the healthcare entity does not promote health for the benefit of its community, then the healthcare entity may not be entitled to a tax-exemption [6].
6. Internal audit considerations. A hospital should consider participating in an internal audit of its operations to determine if there are any practices that could negatively affect its tax-exempt status. Generally, in an internal audit, the auditors would review compensation agreements, contracts, information regarding disqualified parties and any information or reports regarding community benefits. A hospital should also be prepared to answer the more specific questions below:
- Does the hospital have documentation to establish a “rebuttable presumption of reasonableness” for compensation and benefits? When the hospital determines compensation, does it document the proposed compensation compared with compensation paid to similarly situated individuals, which is agreed to and in writing prior to employment? In essence, does the hospital have compensation reports to support the compensation paid in all contracts? How has the hospital documented and assessed incentive compensation that is based on a profit and loss formula?
- Are all transactions fair market value, including those with service suppliers? Are there any disqualified persons or family members or any practice physicians that are in key positions to make decisions for the hospital or the affiliated tax-exempt physician practice? If so, are the contracts signed off on by independent parties?
- How many Medicare, Medicaid and indigent persons are served by the hospital? What percentage of the hospital’s patient population is Medicare, Medicaid or indigent? Does the hospital limit the number of Medicare and Medicaid patients it will serve? Does the hospital turn away patients based upon payor status?
- What percentage of net revenue is uncompensated care? How does the hospital determine who is eligible for free or discounted care? Does the hospital have a written financial assistance/indigent policy? If yes, does the hospital publicize this policy? Is this policy flexible?
- Does the hospital charge its financial-assistance-eligible patients at rates higher than amounts billed to individuals with insurance?
- Does the hospital have a written debt collection policy? What actions does the hospital take before sending a patient to collections? Does the hospital engage in any abusive actions to collect fees?
- What information can the hospital provide regarding its community benefits? Does it provide unreimbursed care? Does it conduct research? Does it educate health professionals? Does it offer health programs to the public? Does the hospital have a community benefit report which lists and describes the community benefit activities the hospital fulfilled on an annual basis?
- Does the hospital participate in any community building activities, such as providing community health improvement advocacy or making environmental improvements?
- Does the hospital conduct a community health needs assessment? If yes, is this information available to the public?
If a hospital cannot adequately or appropriately respond to the questions above, it should implement changes to ensure that its tax-exempt status is protected.
Scott Becker is a partner in McGuireWoods' Chicago office. He practices exclusively in the healthcare regulatory and transactional area. He devotes his efforts to surgery center, hospital and healthcare provider related transactions, joint ventures, securities, contracting and regulatory matters.
Milton Cerny serves as counsel at McGuireWoods' Washington, D.C., office. He represents a broad range of nonprofit organizations including hospitals, private foundations, universities, public charities and trade associations, including U.S. affiliates of foreign charities. He has extensive experience in the application of the federal tax code to nonprofit organizations. He served at the National Office of the IRS in Washington, D.C., where he was responsible for issuing private letter rulings and advising field offices on tax controversies.
Anna Timmerman is an associate in McGuireWoods' Chicago office. Her practice focuses on healthcare transactional and regulatory matters for a variety of healthcare providers, including hospitals, ambulatory surgery centers and dialysis centers.
Footnotes:
[1] Utah County v. Intermountain Health Care, 709 P.2d 265, 274 (Utah 1985); Provena Covenant Med. Ctr. v. Dep’t of Revenue, 925 N.E.2d 1131, 1140, 1149 (Ill. 2010).
[2] Provena Covenant Med. Ctr., 925 N.E.2d at 1140, 1149, 1150; Utah County, 709 P.2d at 274, 275; IHC Health Plans, Inc. v. Comm’r, 325 F.3d 1188, 1196 (3rd Cir. 2003). The IRS does not often revoke tax-exemption status from tax-exempt hospitals.
[3] IHC Health Plans, Inc., 325 F.3d at 1198. HC Health Plans, Inc., a federal case regarding a tax-exempt health plan, stated the following regarding providing community benefit:
An organization cannot satisfy the community-benefit requirement based solely on the fact that it offers health-care services to all in the community in exchange for a fee. [There must be an additional plus.]
. . .
[Regarding community benefit,] the IRS rulings provide a number of examples: providing free or below-cost services, see Rev. Rul. 56-185; maintaining an emergency room open to all, regardless of ability to pay, see Rev. Rul. 69-545; and devoting surpluses to research, education, and medical training, see Rev. Rul. 83-157.
. . .
An organization is not entitled to tax exemption unless it operates for a charitable purpose. Thus, the existence of some incidental community benefit is insufficient. Rather, the magnitude of the community benefit conferred must be sufficient to give rise to a strong inference that the organization operates primarily for the purpose of benefitting the community.
Id. at 1197, 1198.
[4] These individuals typically have authority over transactions to the detriment of the charitable purpose of the hospital.
[5] Some courts have found that failing to publicize such policies weighs against upholding a hospital’s tax-exempt status. Utah County, 709 P.2d at 274; Provena Covenant Med. Ctr., 925 N.E.2d at 1149.
[6] Provena Covenant Med. Ctr., 925 N.E.2d at 1140, 1149, 1150; Utah County, 709 P.2d at 274, 275; IHC Health Plans, Inc., 325 F.3d at 1196.