• IRS Publishes Final Report on Exempt Organizations Hospital Study
  • March 23, 2009 | Author: Christopher J. Swift
  • Law Firm: Baker & Hostetler LLP - Cleveland Office
  • On February 12, 2009, the Internal Revenue Service (IRS) published its Final Report on the Exempt Organizations Hospital Study (Final Report) it began in 2006. Prompted by a growing call from individuals such as Sen. Grassley for nonprofit hospitals to justify their tax-exempt status, the IRS focused its study on community benefit reporting and hospital executive compensation.

    The Final Report is based on 489 responses to questionnaires sent by the IRS to a sample of more than 500 nonprofit hospitals. In addition to these responses, the IRS conducted a more in-depth study of executive compensation paid by 20 nonprofit hospitals, largely chosen because they reported what the IRS initially believed to be high levels of executive compensation. To analyze the data received, participating hospitals were divided among four community types (high-population hospitals, other urban and suburban hospitals, critical access hospitals and other rural hospitals) and five revenue categories (over $500 million in annual revenue, $250 to $500 million, $100 to $250 million, $25 to $100 million and under $25 million).

    Community Benefit Expenditures

    Significant differences were observed in the type and amount of reported community benefit expenditures among the categories. Particularly, the study found that high-population hospitals reported the largest percentage of community benefit expenditures (an average of 12.7 percent of total revenues), while critical access hospitals and other rural hospitals reported the lowest percentages (averages of 6.3 percent and 8.4 percent of total revenues, respectively). Results of the study also showed that these percentages generally increased with revenue size. Of the types of expenses reported by hospitals as community benefit—uncompensated care, medical training, medical research and community programs—uncompensated care made up the majority of reported community benefit expenditures by hospitals in each of the categories, but represented a greater percentage of total community benefit expenditures by low-revenue, critical access hospitals and other rural hospitals. While no correlation was found between community benefit expenditures and the average per capita income of the hospitals’ surrounding geographic areas, community benefit expenditures did tend to increase as uninsured rates in the hospitals’ surrounding areas increased. Though the reported data contained significant limitations (e.g., only a single tax year was analyzed and the criteria for what constituted a community benefit expenditure was largely left to the reporting hospitals), the numbers provide a picture of just how varying the operations and financial capabilities of tax-exempt hospitals are. It is clear, and the IRS acknowledges in the Final Report, that any attempt to revise or refine the current tax exemption standard for hospitals will inevitably and substantially affect the tax-exempt hospital sector.

    Executive Compensation

    Regarding executive compensation, the study found the average reported compensation paid to a top hospital management official to be $490,000, with higher levels paid by high-population and suburban hospitals and lower levels paid by rural hospitals (both critical access and non-critical access). Compensation also tended to increase with increased annual revenue, with top management official compensation by the 20 hospitals investigated in more detail averaging $1.4 million. More significant than the actual levels of compensation, however, was the hospitals’ wide-spread reliance on the rebuttable presumption method for determining compensation. Pursuant to 26 C.F.R. § 53.4958-6, a tax-exempt hospital may establish a rebuttable presumption that compensation paid does not constitute an excess benefit transaction if (1) the compensation arrangement was approved in advance by a governing body of the hospital; (2) the members of the governing body who voted to approve the compensation do not have a conflict of interest; (3) the governing body relied on appropriate comparability data in determining that the compensation was reasonable; and (4) the governing body documented its basis for determining the compensation at the time such determination was made. As a result of its study, the IRS found across-the-board compliance with these requirements, and thus support under existing tax law for current exempt hospital executive compensation.

    Future Scrutiny

    While its recent report is titled “Final,” it is clear that the IRS has not concluded its inquiry into community benefit and executive compensation by tax-exempt hospitals. A substantial revision of the Form 990, Schedule H reporting requirements for exempt hospitals will provide the IRS with more detailed insight into what types of expenses hospitals have traditionally included as “community benefit.” For example, bad debt now must be broken out, with an explanation of what portion is attributable to individuals who qualify for financial assistance under the hospital’s charity care policy and the hospital’s rationale for how much bad debt the hospital believes should constitute community benefit expense. The IRS has also set its sights on the rebuttable presumption method for determining executive compensation, vowing that it “will seek a better understanding of the impact of certain aspects of existing law, including the permitted use of for profit comparables, and the rule excepting the initial contract between the organization and the executive.” What we can be sure of is continued, focused scrutiny of the financial operations and reporting practices of tax-exempt hospitals.