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A Surgical Tool In The Hands Of The Federal Government – Will More Invasive Procedures Follow? The IRS Final Report On Nonprofit Hospitals

Health Law Update Alyce C. Katayama

Culminating its two-year Hospital Compliance Project (the "Project"), the Internal Revenue Service (the "Service") released its much-anticipated Nonprofit Hospital Study Final Report (the "Final Report") on February 12, 2009. Despite the fact that the Final Report bases its conclusions on highly skewed data drawn from only a small sample of hospitals, its findings are likely to have significant effects on future policy debate and regulatory developments. Tax-exempt hospitals will have to work hard in the months and years ahead to prevent the making of uninformed administrative and legislative changes based on these findings. (The Final Report and all of its appendices can be found at

Legal Background

The Final Report focuses on the community benefit standard currently applicable to tax-exempt hospitals and the compensation procedures currently employed by those hospitals. A review of the current state of the law in those areas helps to put the Final Report in context.

Community Benefit

Tax-exempt hospitals achieve that status under Section 501(c)(3) of the Internal Revenue Code of 1986, as amended (the "Code"). The Code does not expressly require those hospitals to provide uncompensated care. Prior to 1969, the Service administratively imposed a charity care requirement, but that was superseded by the community benefit standard adopted in a landmark 1969 Revenue Ruling. Under the community benefit standard, the Service takes various factors into account in determining whether a hospital qualifies for exempt status, including whether:

  1. the hospital has an independent governing body;

  2. hospital medical staff privileges are available to all qualified physicians in the area;
  3. the hospital has a full-time emergency room open to all, regardless of ability to pay; and
  4. the hospital's excess funds generally are applied to the expansion or replacement of facilities and equipment, amortization of debt, patient care improvements, medical education, and research.

A hospital that satisfies these factors would qualify for exempt status under this standard, even if the hospital will admit only inpatients who have the ability to pay for their stay.
In spite of the 1969 ruling and its affirmation in a 1983 ruling, in practice the Service has sought out detailed information from hospitals about their provision of charity care. For example, in 2001 the Service issued field service advice to its agents, offering them a list of 14 questions to use in ferreting out a hospital's approach to charity care. The charity care debate gained national prominence in 2004 when it exploded onto the class action stage in a series of lawsuits. The lawsuits alleged, among other claims, that tax-exempt hospitals violated their express or implied contracts with federal and state government by failing to provide affordable care to indigent patients.

The Congress has taken an intense interest in the charity care topic, with hearings being held by the House Ways and Means Committee and the Senate Finance Committee, among others. Over the course of numerous studies, it became clear that a lack of consistent reporting of charity care and other community benefit expenditures made it difficult to determine how much community benefit tax-exempt hospitals actually provided. For example, at the request of the House Ways and Means Committee, the Government Accounting Office (the "GAO") carried out a study in 2005 and a further study in 2008. The 2008 GAO report found that there was no standard method among tax-exempt hospitals to define "community benefit," and there were substantial differences in the amount of community benefit that they reported. The GAO also found that, even if tax-exempt hospitals define the same activities as community benefit, they measure the cost of those activities differently, which also leads to inconsistencies in reported levels of community benefit.

Executive Compensation

Code Section 4958 imposes a penalty tax on executives and other disqualified persons with respect to many tax-exempt organizations, including tax-exempt hospitals, who are paid excessive compensation. In some cases, an additional penalty tax may be imposed upon members of the governing body that approved the excessive compensation. To avoid authorizing unreasonable compensation and triggering these excess benefit transaction penalty taxes, a hospital's governing body may approve compensation pursuant to a process that is consistent with the rebuttable presumption procedure set forth in the Treasury Regulations under Code Section 4958. To satisfy the rebuttable presumption, the hospital's board of directors or other governing body charged with establishing and approving compensation generally must:

  1. be composed entirely of independent individuals;

  2. obtain and rely on appropriate data as to comparability; and
  3. adequately and concurrently document the basis for its determination. 1

Proper compliance with the rebuttable presumption procedure does not guarantee that an organization will avoid penalty tax, but it shifts the burden to the Service to prove that the compensation approved was unreasonable.

Final Report Background

The Service initiated a study of tax-exempt hospitals in 2006 with the goal of better understanding hospital community benefits and executive compensation practices and reporting. The Service sent questionnaires requesting data on these issues to more than 500 tax-exempt hospitals. Responses from a final group of 487 hospitals were analyzed, and a subset of 20 of those hospitals was selected for examination because, in the Service's opinion, those hospitals paid greater compensation to their executives than would be expected for hospitals of similar size and type.

Interim Report

In July 2007, the Service released an interim report (the "Interim Report") summarizing the data collected from the Project questionnaires. In the Interim Report, the Service noted that the data might not fully depict the community benefit actually provided by the respondent hospitals or the tax-exempt hospital sector as a whole. The Interim Report stated that "the questionnaire did not specify  . . .  a particular method or definition for reporting uncompensated care." In fact, the Service discovered at least 19 different items that might be included in calculating uncompensated care. The respondents varied widely in the extent to which they included or excluded these items. The resulting data were a mystery mix. For example, 18% of respondents included public insurance shortfalls, and 51% included shortfalls associated with self-pay patients. Varying treatment of costs versus charges and direct versus indirect costs further clouded the picture.

Thus, as noted in the Interim Report, the median percentage of total revenue spent on uncompensated care was 3.68% and the mean was 7.44%. Such a huge difference between mean and median shows that the data are seriously skewed, with about half of the respondents clustered at the left tail of the distribution (where half of the hospitals reported a less than 3% uncompensated care level) and about half of the respondents clustered at the right tail of the distribution (with reported charity care levels of between 3% and 50%). The Service identified as a next step in the Project the need to:

Analyze the reported data to determine whether differences in reporting, such as the treatment of bad debt and shortfalls as uncompensated care, could be isolated and adjusted to allow more meaningful comparisons across the respondents.

Unfortunately, as discussed below, that absolutely critical next step was never taken. It is apparent that the Service used the knowledge gained in 2007 to inform the preparation of the new Form 990 Schedule H, which goes to some lengths to distinguish between charges and costs, and to capture discrete information on bad debt and shortfalls in governmental and other payment programs. But that knowledge did not lead to more meaningful comparisons in the Final Report.

Final Report
The Final Report divides its attention between the data collected by the Service regarding community benefit and compensation practices, and the Service's reactions to those data.

Community Benefit

In the Final Report, tax-exempt hospital performance in the community benefit and uncompensated care arenas was compared both by type of hospital (critical access hospitals ("CAH"), other rural hospitals, hospitals in large population centers and other urban/suburban hospitals) and by five groupings based on annual revenue. The median and average percentages of total revenue reported as community benefit expenditures were 6% and 9%, respectively. The percentages reported for community benefit expenditures increased as annual revenue size increased. The Service found that uncompensated care represented the largest portion, 56%, of the aggregate community benefit expenditures reported by the 487 hospitals responding to the project questionnaire. Overall, the median and average percentages of uncompensated care as a percentage of total revenues were 4% and 7%, respectively.

The Service also reported that for the respondent hospitals as a group, revenues exceeded expenses by 5%. Rather than describing this 5% as "net revenue," the generally accepted accounting term, the Service chose instead to label it "excess revenue." The use of this unorthodox and pejorative term to describe a measure of financial strength suggests some bias, especially in the context of a report also focusing on "excess benefit" compensation that is subject to excise taxes and penalties.

The Service found that 35% of hospitals with annual revenue under $25 million were in a deficit position, as were 23% of hospitals in the $25 million to $100 million category, 19% of hospitals between $100 million and $250 million, and 21% of hospitals overall. Hospitals with negative and less than 2.5% "excess revenue" made up 40% of all the hospitals in the study. This is a particularly striking finding, considering that the data in the study came from tax reporting periods covering 2005 and 2006. If the same analysis were to be done on 2008 or 2009 figures, a much bleaker picture of the financial health of the tax-exempt hospital sector would emerge. Given these findings, the industry should be concerned that, if a rigid percentage-of-revenue charity care requirement were to be imposed, administratively or by law, as many as half of all hospitals could find themselves in a deficit position.

Executive Compensation

The Final Report also recognizes the inconsistent reporting practices tax-exempt hospitals have adopted with respect to compensation and benefits. Some hospitals, for example, reported compensation information only for certain individuals and not for others, while other hospitals reported no compensation information at all. Still other hospitals reported compensation data but did not indicate the positions or titles for which that compensation was paid.

Despite those inconsistencies in reporting, the Final Report makes several factual findings regarding compensation:

  • The average and median total compensation paid to the top management officials at tax-exempt hospitals were $490,431 and $377,256, respectively.

  • The average and median salaries and total compensation paid by rural hospitals were lower than the average and median paid by suburban and urban hospitals.
  • CAHs reported the lowest average compensation among the various categories.
  • Seventy-three percent of the respondent hospitals have a formal written compensation policy, including 79% of rural, non-CAH hospitals and 67% of urban hospitals.

The Final Report concludes that nearly all of the respondent hospitals employ key elements of the rebuttable presumption procedure in establishing executive compensation. For example, 98% of the hospitals reported that compensation was approved in advance by independent individuals. Respondent hospitals also reported using a variety of methods to determine the reasonableness of compensation: 87% reported relying upon published surveys, 84% reported using outside experts, and 28% reported using Internet research.
The 20 hospitals selected for examination reported similar use of the rebuttable presumption procedure. In fact, 85% of the examined hospitals properly employed each of the elements of the rebuttable presumption procedure in establishing compensation for top management officials. The Service deferred to each of those hospital's findings of reasonableness, despite the Service's initial opinion that the amount of compensation appeared to be too high.

The Service notes in the Final Report, however, that "there may be a disconnect between what [the public] might consider reasonable, and what is permitted under the tax law. . . . As part of this work, the [Service] will seek a better understanding of the impact of certain aspects of existing law."

Quarles & Brady Comment

The Final Report suggests that the Service is uncomfortable with the current status of the community benefit standard and that the Service is questioning whether compliance with the rebuttable presumption is sufficient to avoid triggering the excess benefit transaction penalty tax.

As any thoughtful observer knows, many of America's tax-exempt hospitals have been under significant financial stress for some time, as they attempt to survive on razor-thin profit margins. The challenges already facing the industry are now exacerbated by the current credit and financial crisis. Add to this the growing numbers of uninsured and unemployed individuals seeking care, then stir in a seriously flawed Final Report from the Service, and you have all the makings of a perfect storm. Unfortunately, good data, which could permit a valid analysis of uncompensated care and community benefit, will not be available until the end of 2011 at the earliest, since the portion of the new Schedule H that deals with charity care and community benefit is not mandated until tax years beginning in 2009. The concern that the hospital industry and its counsel should have is that, despite the fact that the economic underpinnings of our world have shifted and despite the fact that no valid data exist to indicate what level of uncompensated care is actually being provided or how different hospitals perform on this measure, a trigger-happy Congress may nonetheless legislate. Senator Charles Grassley (R-IA), the ranking member of the Senate Finance Committee and one of the most vociferous advocates for reform in this area, has already issued a press release stating that uncompensated care is overstated. He urges the Service to reestablish the more rigid pre-1969 charity care requirements, saying, "If it looks like [that] can't get done, then Congress will have to step in."

With respect to executive compensation, the Final Report confirms that compliance with the rebuttable presumption procedure is advisable: The Service selected hospitals for examination based upon the Service's belief that those hospitals paid larger compensation that was typical for hospitals of similar size. Eighty-five percent of the hospitals selected for examination employed the rebuttable presumption procedure, and the Service ultimately deferred to the findings of reasonableness made by each of those hospitals. Excess benefit transaction penalty taxes will likely be assessed, however, with respect to one or more of the examined hospitals that did not properly employ the rebuttable presumption process.

The Final Report also suggests that, even if a tax-exempt hospital complies with the rebuttable presumption in establishing compensation, the hospital should still consider whether the compensation it pays appears reasonable in light of the hospital's size, location and services. Other commentators have recommended that hospitals add a "common sense" element to their compensation practices, which would include a particular focus on the reasonableness of using for-profit hospitals as comparisons.


The Final Report offers a troubling glimpse into the Service's policy priorities with respect to tax-exempt hospitals. This controversial area of regulation is likely to become subject to even greater scrutiny as the Service and the Congress consider whether the community benefit and executive compensation standards should be revised. Tax-exempt hospitals are strongly encouraged to stay abreast of developments in these areas.

* * *

This update is intended as a general summary of legal matters and not as specific advice to any particular client. If you have any questions concerning the subject matter of this update, please contact one of the authors of this update, Alyce C. Katayama, at 414-277-5823 / [email protected], and Norah L. Jones, at 312-715-5052 / [email protected] or your Quarles & Brady LLP attorney.

1The discussion in the text is intended as only a general summary of the rebuttable presumption and is not a full explanation of its requirements. For guidance regarding the rebuttable presumption process or the excess benefit transaction rules more generally, please contact your Quarles & Brady LLP attorney.

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