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Final Report of IRS Study of Nonprofit Hospital Compliance Answers Some Questions, Raises Others

The Internal Revenue Services ("IRS") on February 12, 2009 issued the final report on its Hospital Compliance Project. Commenced in May, 2006, the Project studied nonprofit hospitals to determine the amount of community benefit provided and how it was reported, and how these hospitals established and reported executive compensation. Comprehensive compliance questionnaires were mailed to 544 nonprofit hospitals regarding the hospitals’ activities, governance expenditures and executive compensation practices. In addition, the Project examined executive compensation issues at 20 hospitals selected based on the high amounts of compensation paid. Both community benefit and reasonable compensation standards have been difficult for the IRS to administer, involving imprecise legal standards applied to complex and varied fact patterns. These challenges are likely to remain unless the applicable standards are revised and clarified.

Community Benefit.
The community benefit standard is the legal standard for determining whether a nonprofit hospital is exempt from federal income taxation under Section 501(c)(3) of the Internal Revenue Code. Through the Project’s questionnaire, the IRS requested information concerning the hospital’s patient mix, emergency room, board of directors, medical staff privileges, and such programs as medical research, professional education and training, uncompensated care, and community programs. The report also examined these factors in light of the level of income and health insurance coverage levels in the surrounding areas. The final report analyzed these factors across all community types and hospital revenue sizes.  

The IRS found considerable diversity in the community benefit activities among the responding hospitals, particularly between critical access hospitals and hospitals in the 26 largest urban areas in the United States ("high-population areas"). The average and median percentages of total hospital revenues reported as being spent on community benefit expenditures were 9 percent and 6 percent, respectively. These percentages were the lowest for rural hospitals and highest for high population hospitals, but they generally increased with the size of the hospital’s revenue. Except for 15 hospitals with large medical research expenditures, uncompensated care was the largest reported community benefit and represented 56 percent of the community benefit expenditures across all demographics. In total, the average and median percentages of uncompensated care as a percentage of total revenues were 7 percent and 4 percent, respectively.   

However, uncompensated care and community benefit expenditures in general were unevenly distributed. Only 9 percent of the responding hospitals reported 60 percent of the aggregate community benefit expenditures for the entire group, and 14 percent of the hospitals reported 63 percent of the aggregate uncompensated care expenditures. Although no correlation was found between community benefit expenditure levels and per capita income levels in the area surrounding each hospital, community benefit expenditures increased as uninsured rates increased in the area, as would be expected.

The responding hospitals overall reported their excess of total revenues over total expenses as being on average 5 percent of total revenues. Reported excess revenues varied depending on the community type and revenue size of the hospital, with hospitals with large revenues generally the most profitable and critical access hospitals as the least profitable. 21 percent of the reporting hospitals reported a deficit, with total expenses exceeding total revenues.

Unfortunately, the usefulness of this community benefit information may be questionable. The IRS notes that there were significant variations in how reporting hospitals defined "community benefit." Some hospitals appeared to report uncompensated care based on customary charges rather than on costs. Some hospitals reported bad debt, Medicare shortfalls and private insurance shortfalls as community benefit, while others elected not to do so. There was neither any independent verification of the numbers reported, nor any requirement that the hospital explain the precise methodology used. This lack of standardized reporting in the industry has been present for some time and should come as no surprise to the IRS. While new instructions for Schedule H to Form 990, which must be completed in its entirety for tax years beginning on or after January 1, 2009, may help with this issue, commentators doubt that this problem will be wholly resolved.  

Executive Compensation
For this part of the Project, the IRS reviewed the process used by each hospital to establish compensation and whether that process met the rebuttable presumption procedures described in Treasury Regulation section 53.4958-6. Under those procedures, compensation to a "disqualified person" such as an officer or manager is presumed to be reasonable in amount if it was established by the following three-pronged, rebuttable presumption process: the organization has an independent governing body, relies on comparability data from other tax-exempt hospitals, and maintains adequate documentation of the process. If this process is followed, then the IRS has the burden of proving that the compensation was excessive as an "excess benefit transaction" under Section 4958 and subject to an excise tax against the disqualified person and possibly the organization manager.  

With respect to executive compensation, the IRS found that nearly all the responding hospitals complied with the important elements of the rebuttable presumption procedures. The average and median total compensation amounts (including benefits) reported for the top management official of the responding hospitals were $490,000 and $377,000, respectively. The average and median total compensation amounts for the 20 specially examined hospitals were $1.4 million and $1.3 million, respectively. Although these numbers appear high, they may be entirely supportable under current law. The rebuttable presumption procedures have been criticized by some in the IRS because they may preclude the IRS from investigating instances of excess compensation.

The questionnaire also asked whether the hospital had any business relationship with any of its officers, directors or key employees, other than through their hospital positions. A surprising 65 percent of the responding hospitals reported at least one such business relationship, with most such persons either furnishing goods or services to the hospital or being a partner or investor in an entity doing business with the hospital. The percentage of hospitals reporting such relationships generally increased with the hospitals’ revenue size.  

Preparing for the Future
Both the components studied in the Final Report are major issues facing the nonprofit hospital industry. Hospital administration should brief the hospital’s governing board on the report, with more detailed information provided to the board’s Finance and Executive Compensation Committees. Hospitals should be prepared for calls from local media reporters concerning how their organization compares with the IRS’ findings concerning executive compensation and community benefit.  

Time will tell whether the new Schedule H to Form 990 and its accompanying instructions resolve the lack of standardization in nonprofit hospitals’ reporting of community benefit. In any event, hospitals should commit sufficient resources to carefully prepare the new Schedule H. In addition, the board should carefully review its process for monitoring and reporting any business relationship between an employee or director and the hospital separate from his or her employment or board position with the hospital.

© 2009 Poyner Spruill LLP. All rights reservedNational Law Review, Volume , Number 237

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About this Author

Wilson Hayman, Health Care Law Attorney, Poyner Spruill Law firm
Partner

Wilson's practice focuses on Health Care Law, Appellate Law, Civil Law, and Administrative Law. Wilson has represented public and private hospital systems as lead counsel in the acquisition and sale of hospitals, physician practices and HMO's; represented health care providers in the formation and operation of provider-owned and controlled managed care organizations, including IPAs, PHOs, MSOs and HMOs; and represented hospitals and physicians in the drafting and negotiation of all types of physician services, recruitment, employment and managed care contracts.

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