Tax-exempt hospitals will soon be the target of a new Internal Revenue Service (IRS) “soft contact audit” initiative, focusing on satisfaction of the “community benefit standard.” This audit initiative was first announced in the IRS Exempt Organizations division’s 2006 Implementing Guidelines and was recently confirmed in comments to the press by several senior IRS officials. The IRS first adopted the community benefit standard in a 1969 Revenue Ruling; it serves as the principal standard under which most hospitals derive their exempt status under Code Section 501(c)(3). The new soft contact audit initiative reflects increasing concern in both Congress and the IRS with the extent to which nonprofit hospitals serve a recognized charitable purpose justifying the benefits of tax-exempt status. As such, it is separate and distinct from the 2004-2005 soft contact audit process, which focused on executive compensation.
This new audit initiative is expected to take the form of a questionnaire, asking the targeted hospitals to provide information on how they satisfy the community benefit standard for purposes of Code Section 501(c)(3) status, how they determine and pay executive compensation (again), and “potentially other issues.”
The purpose of this On the Subject is to alert hospitals as to the pendency of these audits, discuss how the IRS has interpreted the “community benefit standard” in recent years, and provide an outline of likely areas of audit/compliance check review.
Satisfaction of the Revenue Ruling 69-545 community benefit standard depends on a demonstration of appropriate facts, which may include that the hospital (1) operate a full-time emergency room that provides treatment regardless of patients' ability to pay; (2) provide non-emergency services to all individuals who are able to pay, including Medicare and Medicaid beneficiaries; (3) have an open medical staff; (4) have a board of directors composed of independent civic leaders drawn from the community; and (5) use any operational surplus to further the organization's exempt purposes by improving the quality of patient care and advancing the organization's medical training, education and research programs. Revenue Ruling 69-545 imposes no charity care requirements on a tax-exempt hospital other than in an emergency room setting. To the contrary, the ruling specifically recognizes a hospital that referred all charity care cases to the public hospital down the street as tax-exempt.
Recent IRS Position
However, this 1969 IRS position (which is binding precedent on the IRS) is in stark contrast to the more recent IRS position taken in Field Service Advice (FSA) 200110030 (February 5, 2001) (which is not precedential). In FSA 200110030 the IRS indicated that when reviewing the exempt status of a hospital, it would look critically at the amount of charity care the hospital actually provided. The FSA directs the IRS agents to ask 14 questions when reviewing the tax-exempt status of a hospital. These questions include: (a) does the hospital have a specific, written plan or policy to provide free or low-cost health care services to the poor or indigent; (b) under what circumstances might the hospital deviate (or has the hospital deviated) from its stated policies to provide free or low-cost health care services to the poor or indigent; (c) what directives or instructions does the hospital provide to ambulance services about bringing poor or indigent patients to its emergency room; and (d) what documents or agreements does the hospital require poor or indigent patients to sign before receiving care?
Other Sources for Community Benefit/Other Definitional Sources
In addition to FSA 200110030 there are other sources that provide clues as to the details of the IRS examination process. These include the remarks and actions of Senator Charles F. Grassley in his review of certain tax-exempt hospitals, the June 2005 remarks of IRS Commissioner Everson before the U.S. Senate Finance Committee (Chair, Senator Grassley), the Hospital Audit Guidelines released in 1992, the recent revisions to Form 1023 and Form 990, the Senate Finance Committee’s review of American University and American Red Cross, and certain other recent events.
Based on all of these various sources providing perspective on the “community benefit standard,” we have prepared a list of the areas we believe will likely be reviewed during the course of the upcoming audits. The list below is not a list of legal standards that must be met by tax-exempt hospitals. Rather, it reflects those items we expect the IRS (as well as Congress, local legislators and the media) to target in the near future.
Despite the fact that the IRS’s official position indicates that charity care outside of the emergency room is not required for tax-exempt status, tax-exempt hospitals have typically provided some level of charity care. Accordingly, a tax-exempt hospital should be prepared to demonstrate how charity care is identified, calculated, accounted for and documented as well as how its availability is communicated to the public. Special attention should be placed on the hospital’s ability to answer the specific questions set forth in IRS Field Service Advice 200110030.
Expect focus on the degree of independence among the members of the governing board of the hospital and, where applicable, of the parent corporation. Congressional statements, the Panel on the Nonprofit Sector’s Final Report to Congress, the American University situation and revisions to Form 1023 and 990, all suggest that the structure, size and constitution of the governing board may be a more significant component of community benefit than it was in 1969.
Conflict of Interest Policy and Procedure
A likely target will be policies and procedures that reflect a sensitivity to, and oversight of, conflicts of interest at the governing board level and of the duty to disclose and fairly resolve potential conflicts.
As evidenced by the 2004-2005 IRS soft contact audits, the process by which (reasonable) executive compensation is determined and the transparency of that process will play an increasingly significant role in regulators’ perspectives on whether tax-exempt status is warranted.
Periodic Mission Reviews
Both Congress and the IRS increasingly ask whether tax-exempt hospitals periodically assess the organization’s performance and effectiveness as they relate to its charitable mission.
Review of Board Minutes and Key Committee Minutes
Board and key committee minutes continue to be areas of IRS review in almost every audit to the extent they reflect the presence of an informed, disinterested decision-making process. The minutes should reflect the charitable nature of activities and not just the financial performance of such activities.
The IRS released its formal position on physician recruitment in 1997 (Rev. Rul. 97-21). Since that time, the IRS has been silent on the issue.
Incentive and Deferred Compensation
A likely area of interest will be evidence that all incentive and deferred compensation arrangements (executive and physician) were appropriately determined, reviewed and documented.
Governance Best Practices
While no one would ever suggest that “best practices” have a direct role in obtaining or maintaining tax-exemption, their adoption is reflective of the governing board’s “good faith.”
In his public comments and actions through the Finance Committee, Senator Grassley has expressed great interest in the widespread practice of nonprofit hospitals investing in joint ventures with physicians and other third parties and how they further a hospital’s tax-exempt purposes. (However, the IRS has not been active in this area.)
Congress and members of the public have been focusing on offshore accounts and companies more frequently. There is particular focus on their purpose and the reimbursement of travel and entertainment expenses of corporate directors associated with attendance at board meetings.
Travel (Including Spousal Travel) and Entertainment Expenses
Of all the tax issues that exist in the nonprofit world, few are more attractive to media outlets and Congress than an organization’s practices and procedures with respect to travel and entertainment expenses, spousal travel and club dues.
What is the appropriate spending authority of a chief executive officer? What is the distinction between “personal” and “business-related” expenses? What are the related intermediate sanctions and individual income tax implications?
Medical Staff Perquisites
Frequently a source of IRS scrutiny and concerns, any benefits provided to medical staff and/or the board of directors should be reviewed.
We recommend that tax-exempt, nonprofit hospitals prepare for receipt of a community benefit soft contact audit request. Our experience advising clients responding to the 2004-2005 executive compensation audits suggests that such preparation might logically include reviewing community benefit activities and the collection, documentation and dissemination of information about such activities. Hospitals that will be successful in responding to these audits are likely to be those that have a specific strategy for responding to a range of community benefit-related issues. Those hospitals that are not selected to participate in soft contact audit process should nevertheless expect to receive increased “spill over” scrutiny on community benefit matters from local community interest groups and the media.