Chapter 10.B.2--Charitable Tax Exemption

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For a good practical overview of federal requirements for hospitals and clinics, including a discussion of joint ventures, see the IRS document Health Care Provider Reference Guide.

Litigation has erupted over hospital tax exemption.  Prominent planiffs lawyers who previously sued the tobacco and HMO industries have brought dozens of class action lawsuits against nonprofit hospitals, contending that they failed to live up to charitable promises and obligations, in a variety of ways, including:  turning away deserving patients who cannot pay, charging uninsured patients much more for services than insured patients, and aggressively pursuing collection of bills against low-income patients.  Causes of action include third-party breach of contract with taxing authorities, breach of charitable trust, and violation of state law consumer protection and fair debt collection practices.  So far, almost every suit has been dismissed.  According to one court:

Plaintiffs here have lost their way; they need to consult a map or a compass or a Constitution because Plaintiffs have come to the judicial branch for relief that may only be granted by the legislative branch. This action is one of dozens of similar bootless actions filed in twenty-three district courts across the United States on behalf of uninsured and indigent patients, wherein Plaintiffs argue, without basis in law, that private non-profit hospitals are required to provide free or reduced-rate services to uninsured persons. More specifically, Plaintiffs claim that the rates charged by the defendant hospital to uninsured patients are unreasonable merely because various insurers have negotiated with the hospital to pay lower rates-an economically efficient outcome for both sides that is fully sanctioned by New YorkNew York” are devoted to statistics of the kind normally associated with legislative hearings. . . . These are all “facts” and arguments that should be addressed to the political branches-perhaps, in this case, the New York Legislature-not the judicial branch. As set out below, the arguments Plaintiffs attempt to dress up as judicial branch arguments are all without merit. Indeed, at oral argument in this case, Plaintiffs' counsel conceded that two of Plaintiffs' claims should be dismissed. Plaintiffs around the country have fared no better.  This orchestrated assault on scores of nonprofit hospitals, necessitating the expenditure of those hospitals' scares resources to beat back meritless legal claims, is undoubtedly part of the litigation explosion that has been so well-documented in the media.

Kolari v. New York-Presbyterian Hosp., 2005 WL 710452  (S.D.N.Y., March 29, 2005).  See also Kizzire v. Baptist Health System, Inc., 441 F.3d 1306 (11th Cir. 2006).
For the current status of this ligitgation, see BNA Pending Litigation Chart.  For information from the plaintiffs' counsel, see the Not-For-Profit Hospital Class Action Litigation web site.  The American Hospital Association also maintains a relevant website, focusing on hospital Billing and Collection Practices.  See also Lisa W. Clark, et al., What May Arrive in Tomorrow's Mail?: An Analysis of Class Action Lawsuits Concerning Hospital Billing of Uninsured Patients, 13 BNA Health L. Rep. 1134 (July 29, 2004).

Accompanying this litigation has been increased focus and controversy over hospitals' billing and collection practices for patients who pay out of pocket.  Conventionally, hospitals maintain a set of "list prices" called a "chargemaster" that are much higher than what they actually receive from Medicare, Medicaid, or private managed care plans.  However, these high list prices are what they routinely charge patients who pay out of pocket, including indigent or uninsured patients.  Hospitals maintain that good business practices, and various federal regulations, require them to do so.  Federal regulators claim that hospitals are overinterpreting their requirements (such as the "anti-kickback" statute discussed in section E).  For additional discussion and analysis, see U.S. Senate Finance Committee, Hearings on Charity Oversight and Reform (June 22, 2004); DHHS, Questions On Charges For The Uninsured (Feb. 2004); DHHS, Hospital Discounts Offered To Patients Who Cannot Afford To Pay Their Hospital Bills (Feb. 2004).  See generally, Community Catalyst, Not There When You Need It: The Search for Free Hospital Care (Oct. 2003); Saul Weiner, et al., Rationing Access to Care to the Medically Uninsured: The Role of Bureaucratic Front-Line Discretion at Large healthcare Institutions, 42 Med. Care 306 (2004); American Hospital Association, Billing and Collection PracticesGeorge A. Nation, Obscene contracts: the doctrine of unconscionability and hospital billing of the uninsured. 94 Ky. L.J. 101-137 (2005-2006); Beverly Cohen, The controversy over hospital charges to the uninsured--no villains, no heroes. 51 Vill. L. Rev. 95-148 (2006); Symposium, 25(1) Health Aff. 44 (Jan. 2006); Comment, 78 Temp. L. Rev. 493 (2005).

This controversy has resulted in state-court litigation over the ability of hospitals to enforce these inflated charges, or the ability of patients to obtain refunds.  So far, courts are split. Compare Cox v. Athens Regional Medical Center, Inc., 631 S.E.2d 792, 798-99 (Ga.App. 2006) (finding that hospital has no obligation to charge only “reasonable” rates); same Morrell v. Wellstar Health System, Inc., --- S.E.2d ----, 2006 WL 1679691 (Ga.App.,2006) (same); DiCarlo v. St. Mary's Hosp., Slip Copy, 2006 WL 2038498 (D.N.J.,2006.); with River Park Hospital v. Bluecross  Blueshield of Tennessee, 173 S.W.3d 43 (Tenn. 2003) (hospital rates must be objectively reasonable); Temple Univ. Hospital v. Healthcare Management Alternatives, 832 A.2d 501 (Sup. Ct. Penn., 2003) (same).

In an important decision similar to Geisinger, the 10th Circuit upheld the IRS’s denial of exemption to a hospital-based HMO, applying a stringent test that requires the HMO to show that conferring community benefits is its primary purpose. IHC Health Plans v. Commissioner of Internal Revenue, 325 F. 3d. 1188 (10th Cir. 2003).   In its discussion of the community benefit test, the court stated that “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. . . . Rather, the organization must provide some additional ‘plus.’”   First on the list of these “pluses” was “free or below-cost services,” though the court acknowledged that “devoting surpluses to research, education and medical training” might also suffice.  For commentary, see John D. Columbo, The Failure of Community Benefit, 15 Health Matrix 29 (2005).

In line with the Utah County case, cases in Illinois have also held that writing off even large amounts of bad debt is not the equivalent of charity care, and does not justify charitable property tax exemption.  See Riverside Medical Center v. Dept. of Revenue, 795 N.E.2d 361 (2003).

Prof. Jill Horwitz argues that hospital need not provide more charity care than for-profits in order to justify tax exempt status.  Instead, it suffices that they provide a broader range of services, including those that are not profitable.  Jill R. Horwitz, Why we need the independent sector: the behavior, law, and ethics of not-for-profit hospitals, 50 UCLA L. Rev. 1345-1411 (2003).  John Colombo argues for a looser test for exemption based on enhancing access to care in the community, more than for-profit counterparts, where this can be documented.  John Colombo, The Role of Access in Charitable Tax Exemption, 82 Wash. U. L. Q. 343 (2004).  See generally, Jack E. Karns, Justifying the nonprofit hospital tax exemption in a competitive market environment, 13 Widener L.J. 383-561 (2004); Symposium, 25(4) Health Aff. w287 (Aug. 2006); Comment, 20 Rev. Litig. 709 (2001); Symposium, 15 Health Matrix 5 (2005)

As the update to Chapter 10.A discusses, there has been a sharp increase in the number of specialty hospitals, which do not usually have emergency rooms.  This is in response to several business factors:  physicians are creating for-profit specialized facilities that target more profitable areas of care; these hospitals tend to attract fewer Medicaid patients; and without emergency rooms, they tend to receive fewer uninsured patients.  For an overview of recent trends, see U.S. Government Accounting Office, Specialty Hospitals:  Geographic Location, Services Provided, and Financial Performance (GAO-04-167, Oct. 2003).  The report summarizes:

Advocates of these newer specialty hospitals contend that the focused mission and dedicated resources of specialty hospitals allow physicians to treat more patients needing the same specialty services than they could in general hospitals and that, through such specialization and economies of scale, the potential exists to improve quality and reduce costs. In contrast, critics are concerned that specialty hospitals may concentrate on the most profitable procedures and serve patients that have fewer complicating conditions—leaving general hospitals with a sicker, higher-cost patient population. They contend that this practice of drawing away a more favorable selection of patients makes it more financially difficult for general hospitals to fulfill their broad mission to serve all of a community’s needs, including charity care, emergency services, and stand-by capacity to respond to communitywide disasters. Critics have also raised concerns that physician ownership of specialty hospitals creates financial incentives that could inappropriately affect physicians’ clinical and referral behavior.
See also David Shactman, Specialty Hospitals, Ambulatory Surgery Centers, and General Hospiotals: Charting a Wise Public Policy Course, 24(3) Health Aff. 868 (June 2005).

Regarding whole hospital joint ventures, in St. David’s Health Care System v. United States, 349 F. 3rd  232 (5th Cir. 2003), the court found that a fact issue existed over whether a nonprofit hospital had ceded operational management to Columbia/HCA.  The court found rejected the trial court's summary judgment ruling that the particular structure adequately protected the board’s control over the hospital’s charitable purpose, noting that the hospital had only a 50% share of the voting control over the joint venture and that the manager was paid a percentage of net revenues, which creates an incentive to maximize profits.  For commentary, see Gary J. Young, Federal Tax-Exemption Requirements for Joint Ventures Between Nonprofit Hospital Providers and For-Profit Entities, 13 Ann. Health L. 327 (2004)

Here is more information about IRS exemption rulings affecting complex corporate systems.

1. Shared Services. Hospitals sometimes find it efficient to operate certain internal functions such as laundry services on a shared, cooperative basis with other hospitals. Undue attention has been devoted to whether such supporting enterprises are themselves tax exempt. Ordinarily, the answer would be no because, while laundry services within a hospital clearly are related to the hospital's function, standing alone they do not constitute a charitable enterprise. However, section 501(e) provides a special exemption for "cooperative hospital service organizations" that perform the following services for tax-exempt hospitals: "data processing, purchasing, warehousing, billing and collection, food, clinical, industrial engineering, laboratory, printing, communications, record center, and personnel." Owing to effective lobbying from commercial laundries, laundry services are notably absent from this list, though. HCSC-Laundry v. U.S., 450 U.S. 1 (1981). Construing this precedent, the IRS has ruled that a cooperative service organization loses its entire exemption if any of its activities are not on the list enumerated in the statute. Tech. Advice Mem. 9542002 (July 18, 1995) (shared security, parking, and housekeeping services are impermissible).

One way around this restrictive statute is to characterize a supporting institution as an "integral part" of an exempt organization. Scattered precedents allow subsidiaries to qualify as an integral part of a charitable whole even if, standing alone, they do not perform charitable activities, so long as the activity would be "related" if it were performed internally by the charitable parent. This doctrine was given a restrictive interpretation, however, in a court decision concerning an HMO run by a hospital. Based on some obscure reasoning, the court essentially ruled that an HMO is too different from a hospital to qualify for exemption under the integral part test. Geisinger Health Plan v. Commissioner, 30 F.3d 494 (3rd Cir. 1994).

2. Hospital Reorganization and Integration. There are two tax exemption issues in vertically integrated networks: (1) which subsidiaries will lose exemption if their functions are examined separately from the hospital's; and (2) will the holding parent company qualify for exemption even though it is a "shell" corporation that offers no charitable service directly, and even though a number of its subsidiaries are run as for-profit ventures? The answer to the former is explored above in terms of each of a number of different health care ventures (HMO, nursing home, physician group practice, etc.). The answer to the latter is generally yes, following the "integral part" thinking described above. The leading ruling is Northwestern Medical Corp., described in Tax Notes, Sept. 9, 1993, where the IRS approved the exemption of a "superparent" for a regional hospital network composed of several hospital systems, each with its own exempt parent.  In Wilson Area School District v. Easton Hosp., 747 A.2d 877 (Pa. 2000), the court upheld the charitable status of a non-profit hospital that owned a number of for-profit subsidiaries because the subsidiaries helped to further the hospital's general health care purposes.  See generally Melvin Horowitz, Corporate Reorganization: The Last Gasp or Last Clear Chance for the Tax-Exempt, Nonprofit Hospital?, 13 Am. J. L. & Med. 527 (1988); Mary Squires, Corporate Restructuring of Tax-Exempt Hospitals: The Bastardization of the Tax-Exempt Concept, 14 Law, Med. & Health Care 66 (1986); General Counsel Memorandum 39508 (May 28, 1986); General Counsel Memorandum 39598 (Dec. 8, 1986).

A further complication is whether independent hospitals can qualify for the "integral part" treatment if they affiliate with each other but do not form an outright parent-subsidiary relationship. Ordinarily, these affiliations would fall under the "shared services" rule above, which strictly limits the scope of exemption when one hospital provides services to other hospitals. In recent rulings, however, the IRS has stated that nonprofit hospitals can affiliate and still maintain exemption if they form "joint operating agreements" in which they cede operational authority to a single entity. These arrangements are considered to be functionally equivalent to a parent-subsidiary relationship sufficient to avoid the shared services limitation and to qualify for the integral part treatment. See 5 BNA Health L. Rep. 1713 (1996).

3. Payroll Taxes for Contracting Physicians. General Counsel Memorandum 39862 clarifies that compensation and payment incentives are much less controversial when they are in exchange for tangible services performed by the physician. Then, the only test is one of commercial reasonableness. Arrangements where the hospital bills directly for the services of hospital-based physicians and then compensates them with a portion of the receipts are not as uncommon as the GCM suggests; the reimbursement changes it describes relate only to Medicare, not to private insurance. Indeed, under capitation payment, bundling of hospital and physician services is becoming even more common.
This raises a different tax issue of some importance, however, namely whether as indicated in n.3 of the GCM, these physicians are to be considered employees rather than independent contractors. Hospitals greatly prefer the independent contractor label, not only because they avoid payroll taxes, but also because of vicarious liability and corporate practice of medicine considerations. The IRS, however, has cracked down on this characterization with numerous hospital audits resulting in some very large demands for back taxes. See Tech. Advice Memoranda 9535001-9535002 (1995). These rulings are causing great consternation and are likely to be challenged in court. One went so far as to opine that a radiologist with an independent practice who reads electrocardiograms part time at several different hospitals and is paid piece work could still be classified as a part-time employee at each hospital. The best route to avoiding this result is for a physician to employ herself through a professional corporation which then contracts with the hospitals. It is much harder to characterize a corporation as an employee.

4. Taxation of Health Insurance. One more point is necessary to have a complete picture of health insurance taxation. Health insurers that are taxable face the accounting question of whether anticipated loss payouts and contributions to their capital reserves count as business expense deductions that lower their earned income. To answer this question, the tax laws have devised special, favorable accounting rules that apply only to insurers. For a while, the IRS resisted extending these accounting rules to HMOs, under the logic expressed in Jordan (page 1323) that they are not insurers, but it has since relented. See B. Brooke, T. Dirig & M. Yuhas, Taxation of HMOs after Section 461(h) and General Dynamics, 68 J. Tax'n 329 (1988).

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