IRS Report Provides Insight into Community Benefit and Executive Compensation Practices of Tax-Exempt Hospitals

Posted by Jason Greis on February 15, 2009 under Articles | Read the First Comment |  Print

On February 12, 2009, the Internal Revenue Services released its long-anticipated final report (the “Report”) containing the results of a two-year study focusing on community benefit reporting practices and executive compensation practices of tax-exempt hospitals.  The results are based on a survey the IRS sent to 500 tax-exempt hospitals in May 2006, and builds on analysis of results first released by the IRS in an interim report in July 2007. 

While the Report comes amid continued questioning over whether tax-exempt hospitals are doing enough to justify their tax exemption, the Report fails to reach specific conclusions concerning whether the existing community benefit standard is appropriate and whether tax-exempt hospital executives are being compensated appropriately.  Nonetheless, the findings, an overview of which are provided below, are worthy of mention to LTACH Administrators and CEOs, Chief Financial Officers and Directors, in particular, to members of the compensation committee.  For-profit LTACHs should also note that a similar survey may be sent to for-profit hospitals in the near future.

The Current Community Benefit Standard.

 The current “community benefit” standard was established by the IRS in 1969 in Revenue Ruling 69-545.  The standard sets out factors to be considered in measuring community benefit, including: (i) a board made up of a broad base of community members; (ii) an open medical staff; (iii) participation in Medicare and Medicaid; (iv) application of surplus funds toward improving facilities, equipment, patient care, medical training, research, and education; and (v) a full-time emergency room open to all regardless of ability to pay (the emergency room standard applies differently to tax-exempt LTACHs that do not maintain a full array of emergency department services).  Under the current community benefit standard, individual hospitals are given flexibility to determine what services will best serve their communities.

Findings Show that Tax-Exempt Hospitals Provide Substantial Community Benefit–Depending on How “Community Benefit” was Defined.

The Report found that responding hospitals spent an average of 9% of their total revenues on providing community benefit, including free medical care, education, and research.  58% of hospital in the study reported uncompensated care amounts of less than or equal to 5% of total revenue.  Slightly more than 20% of the hospitals reported aggregate community benefit expenditures of less than 2% of total revenue.  Uncompensated care was the largest reported community benefit expenditure overall, accounting for 56% of aggregate community benefit expenditures reported by tax-exempt hospitals in the study.  Average and median percentages of uncompensated care as a percentage of total revenues totaled 7% and 4%, respectively. 

The Report contains positive and negative news with respect to the amount and types of community benefit being provided.  For example, while the Report shows that tax-exempt hospitals are doing a worthy job as a whole in providing uncompensated care, and that such care is the largest component of the community benefit matrix, critics will likely note that community benefit and charity care spending are concentrated in a relatively small number of hospitals.  Furthermore, many hospitals included uncompensated care based on bad debt, Medicare shortfalls, and private insurer shortfalls in their definitions of community benefit.  Some commentators believe that there is a risk that Congress, state legislatures, and state attorneys’ general will use the percentages of community benefit and uncompensated care in the Report to establish inflexible minimum community benefit standards similar to the minimum standards introduced by Illinois Attorney General Lisa Madigan in 2005, and which have repeatedly been proposed by Senator Charles Grassley.

Senator Grassley Disappointed that the Report Fails to Provide a Definition of “Community Benefit.”

During the last several years members of Congress have raised concerns over whether tax-exempt hospitals provide enough free care and other community benefits to justify their tax exemptions.  Senator Grassley, in particular, has been an outspoken critic of the amount of community benefit and charity care provided by the tax-exempt hospital sector.  He commented that while the Report reflects a significant effort by the IRS, he was disappointed that it did not go further by providing guidance to hospitals on how to define community benefit and uncompensated care.  Senator Grassley also expressed disappointment that the Report did not include data on for-profit hospitals’ level of uncompensated care and other community benefits and compensation.  Expressing his concern, Senator Grassley commented that:

Neither the IRS nor Congress has done a very good job when it comes to establishing the criteria for enjoying this tax[-exempt] status since the IRS scrapped charity care for its community benefit standard in 1969 [in Revenue Ruling 69-545]. The Treasury Department could do a lot of good, and probably more quickly than Congress, by re-establishing those charity care requirements, and if it looks like that can’t get done, then Congress will have to step in.

Senator Grassley threatened in December 2008 to bring back rigid community benefit and charity care standards for tax-exempt hospitals that existed prior to the IRS’s release of Revenue Ruling 69-545. 

Partly in response to the Report, Senator Grassley has attempted to persuade House and Senate compromise committee conferees on the economic stimulus bill (H.R. 1) (the “Bill”) to include two amendments in the final version of the Bill to be signed by President Obama, after a cloture vote cut off further amendments to the Senate bill.  The two amendments would require: (i) the Centers for Medicare & Medicaid Services to coordinate with the IRS and the Medicare Payment Advisory Commission to develop a single, uniform definition of uncompensated care and charity care, and (ii) the IRS to study the activities of for-profit hospitals, particularly the amount of uncompensated care they provide.  Senator Grassley and Senator Jeff Bingaman, Senate Finance Committee ranking member and committee member, respectively, are considering introducing legislation to establish new charity care and community benefit standards for tax-exempt hospitals and accountability measures for those standards to replace those currently required under Revenue Ruling 69-545 if the amendments are not ultimately included in the Bill.

Some Executive Compensation May be High but Generally Appears to be Established According to the Rebuttable Presumption Safe Harbor.

According to a summary of the Report, CEOs of tax-exempt hospitals earned $490,431, on average, in total compensation.  Overall trends from the Report indicate that higher compensation was paid to executives at larger urban hospitals and hospitals with higher revenues.  “Amounts reported appear high but also appear supported under current law.  For some, there may be a disconnect between what, as members of the public, they might consider reasonable, and what is permitted under the tax law,” the IRS said.  Some CEOs of tax-exempt hospitals are concerned that the Report may instigate a visceral response from members of Congress who may, in turn, attempt to enact legislation that would limit executive compensation for tax-exempt organizations, much in the way that it has done for Wall Street executives.

The IRS said that it would continue its enforcement work in this area through examinations of executive compensation and other compliance initiatives.  As part of this work, the IRS intends to seek a better understanding of the impact of certain aspects of existing law, including the permitted use of for-profit comparables when establishing executive compensation for tax-exempt executives (e.g., using the salaries of comparable executive positions at for-profit organization to establish executive compensation for tax-exempt executives).

The Report showed that nearly all examined compensation amounts were upheld as established according to the IRS’s rebuttable presumption process and within the range of reasonable compensation.  Exempt organizations officials noted that while 85% of respondents to the IRS’s study used the rebuttable presumption to set salaries, 15% did not.  In at least one instance, compensation was excessive under IRS rules. 

The rebuttable presumption of reasonableness established under IRS Code Section 4958 is a safe harbor for setting executive compensation that is intended to keep tax-exempt officials from being hit with penalties for providing excessive compensation to their top executives.  A tax-exempt hospital may create a rebuttable presumption that the amount of compensation it pays is reasonable, and therefore not considered an excess benefit, when: (i) the compensation arrangement is reviewed and approved by the organization’s disinterested and authorized governing body; (i) the authorized body determines the reasonableness of compensation using and relying upon appropriate comparability data, such as similarly situated tax-exempt (and arguably for-profit organizations), functionally comparable positions, and compensation surveys compiled by independent firms; and (iii) the authorized body adequately and concurrently documents the basis for its determination.

What’s Next for Tax-Exempt Hospitals–Changes to Internal Revenue Code Sections 501(c)(3) and 501(c)(4).

Since mid-October 2008, Senator Grassley has promised to introduce bi-partisan legislation to establish national, quantifiable community benefit standards.  No bill has been proposed to date, but Senator Grassley’s legislative activities should be closely monitored as they appear to be gaining traction and Democratic support. 

Senator Grassley has often advocated in favor of Congress legislating special rules for hospitals seeking tax-exempt status under Sections 501(c)(3) and 501(c)(4) of the Internal Revenue Code.  In particular, he has proposed making the requirements for obtaining Section 501(c)(3) tax-exempt status more stringent than those for obtaining Section 501(c)(4) status since 501(c)(3) organizations are eligible for tax-exempt bond financing and are eligible to receive tax-deductible contributions in accordance with Code Section 170.  In a blog posting that will be released later this week, I will discuss Senator Grassley’s proposals for changing the requirements for obtaining and maintaining 501(c)(3) status that may appear in legislation proposed by Senator Grassley later this year.

Jason S. Greis
312.849.8217
jgreis@mcguirewoods.com