November 1, 2004

Recent Scrutiny of Tax-Exemption for Nonprofit Hospitals: Is Your Hospital As Compliant As You Think?

Lisa Hawke

The convergence in the summer and fall of 2004 of the IRS Tax Exempt Compensation Enforcement Project, three separate Congressional hearings and the filing of numerous law suits challenging various hospitals’ tax-exempt status, indicate unprecedented scrutiny of Section 501(c)(3) requirements for hospitals and related hospital billing and collection practices.  It is very significant that questions regarding compliance for tax-exempt hospitals and other entities have been raised in all three branches of the federal government.  This scrutiny should prompt hospital executives to take a fresh look at their compliance.  

Federal Scrutiny of Tax-Exemption in All Three Branches of the Government

Congress.  The Senate Finance Committee is revising its "conceptual draft" legislation for changes regarding oversight of tax-exempt entities, and interest remains strong in the Congress  to examine whether organizations receiving federal tax exemption are deserving of it. More Congressional hearings will likely occur in the future, and it is possible that legislation will be introduced, seriously considered and possibly enacted. Ultimately, these developments may result in the legislative or regulatory imposition of new compliance obligations on all types of tax-exempt organizations, and new billing and collection requirements on hospitals specifically.

Internal Revenue Service.  The IRS has sent “compliance check” letters to approximately 2,000 charities and foundations seeking information about compensation practices and procedures. The IRS has also revised the application form for obtaining Section 501(c)(3) tax exemption to request far more detailed information about compensation and other financial arrangements between the organization and its officers, directors and employees.

Courts.  Fortunately, a number of federal lawsuits challenging the tax-exemption of nonprofit hospitals have been dismissed.  Challenges continue to be filed, however, in state court venues and the issue is not yet finished. 

Is Your Hospital As Compliant As You Think?

The relative security many Section 501(c)(3) hospitals have traditionally felt in their compliance with Section 501(c)(3) requirements – including the “rebuttable presumption of reasonableness” as to compensation packages and vague “community benefit standard” – is diminishing due to the Congressional hearings, increased IRS activity and recent litigation.  Hospital executives should not be falsely comforted by the limited nature of prior IRS enforcement or by their belief in their hospital’s compliance due to prior audits and compliance activities. Even if prior audits or compliance programs have been undertaken, tax-exempt hospitals are entering new and uncharted waters and the rules may soon be changing and enforcement evolving.  Several examples of perceived but inadequate compliance include:

  • an appropriate hospital charity care policy that is inadvertently contradicted or undermined by other hospital policies, procedures and other documents; ensuring that the “paper trail” (including annual report, strategic plan, policies and procedures, etc.) adequately and consistently documents the hospital’s commitment to all Section 501(c)(3) requirements, not only those related to providing community benefit, is essential to the maintenance of federal tax-exempt status
  • determining executive compensation based upon inadequate comparability data or without taking into account certain components of the overall compensation package; examples include a deferred compensation arrangement, a loan made on an interest-free basis or at a below-market interest rate, or a lease of office space at a below-market rental rate

Fresh Review of Compliance Risk is Prudent

Section 501(c)(3) hospitals should undertake a fresh review of their compliance with federal tax-exemption requirements, particularly if it has been the recipient of an IRS "compliance check" letter.  The evaluation should be conducted by legal counsel, whether internal or external, to ensure attorney-client privilege and include:

  • Review current policies and procedures – examine hospital documents, policies and procedures related to federal tax-exemption and related billing and collection practices; survey of appropriate hospital officials to identify compliance issues and potential problems; review specified governance documents, institutional policies, contractual arrangements and other written materials; review relevant components of the hospital’s compliance program dealing with tax-exemption, and billing and collection practices. 
  • Affirm areas of compliance – affirm and document the areas in which the hospital is compliant with current legal standards. 
  • Determine areas of compliance risk – analyze hospital practices, policies and documentation relevant to federal tax-exemption, and billing and collection practices, applying current legal standards to determine areas of compliance risk and exposure; identify any areas of vulnerability in light of existing legal standards, as well as evolving new standards arising from the current legislative and regulatory activity and oversight, and the ongoing class action litigation. 
  • Implement appropriate changes to address compliance risk – outline any areas of vulnerability under current legal standards and in light of potential regulatory and legislative changes; implement appropriate changes to reduce the risk of being challenged, and of losing federal tax-exempt status; outline areas of vulnerability, and provide further recommendations related to overall compliance policies and procedures; ensure any additional ongoing compliance and risk avoidance strategies and/or measures as appropriate. 
  • Consider creating a multi-disciplinary Community Benefits Committee – to formalize and embody the hospitals charitable mission in a specific committee; the committee will also help ensure continued future compliance by reviewing critical documents, policies and procedures going forward; this committee may include essential leaders in the hospital including legal counsel, financial and billing, and community services among others. 

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