• Stealth Can Be Good: New Procedure Allows Governmental Entities to Relinquish Section 501(c)(3) Tax-exempt Status
  • January 6, 2012 | Author: Elizabeth M. Mills
  • Law Firm: Proskauer Rose LLP - Chicago Office
  • A new provision which was slipped in to the annual announcement of procedures for exempt organization determinations and letter rulings provides a way for governmental entities to voluntarily terminate their Section 501(c)(3) status. This is important for governmental hospitals that otherwise could be faced with new exemption requirements and penalties.

    In the past, many local governmental entities, such as hospital authorities or hospital districts, obtained determinations from the IRS that they were tax-exempt organizations described in Section 501(c)(3) of the Internal Revenue Code. A common reason for obtaining recognition of Section 501(c)(3) status (in addition to their sovereign immunity as governmental entities from federal income tax) was so that the governmental entity’s employees could take advantage of Section 403(b) tax-sheltered annuities.  (A government entity may not establish or maintain a Section 401(k) plan unless it adopted the plan before May 6, 1986.  While governmental entities are permitted to maintain Section 457(b) plans, which are defined contribution plans providing for employee contributions similar to Section 401(k) plans, Section 457(b) plans are subject to lower contribution limits than the overall contribution limits for Section 401(k) plans and Section 403(b) annuities).

    Section 501(c)(3) governmental entities were relieved of the burden of having to file a Form 990, which at that time was really the only disadvantage to Section 501(c)(3) status. (Governmental educational institutions were already subject to unrelated business income tax on their income that would have been taxable had they not been governmental institutions.) When the “intermediate sanctions” applicable to transactions with public charities became effective in 2005, imposing potential excise taxes on persons involved in transactions with Section 501(c)(3) organizations that were not public charities, the implementing regulations specifically provided that governmental entities with Section 501(c)(3) recognitions were not covered.

    Not only were there no significant disadvantages to maintaining Section 501(c)(3) status, but there appeared to be no way to relinquish the status once obtained. Old general counsel’s memoranda and IRS Continuing Professional Education texts said so, although relinquishment was not apparently prohibited under the Code.

    The enactment of Section 501(r) of the Code posed a very real burden on governmental hospital entities holding Section 501(c)(3) status determinations. Section 501(r) imposes specific requirements that hospitals must meet to remain tax-exempt, including a requirement that each hospital conduct a “community health needs assessment” (“CHNA”) every three years . Not only can hospitals lose their tax exemption if they do not conduct a CHNA - which may be a desired outcome for a governmental hospital - but they are also subject to a $50,000 excise tax for each year that each hospital facility does not conduct a CHNA - obviously not a desired result.

    The deadline for the first round of CHNAs is coming up. Hospitals that do not have a CHNA in place by the end of their third tax year ending after March 23, 2010 are noncompliant and subject to penalties.  For example, a hospital with a June fiscal year end must have a CHNA in place by June 30, 2013.

    The IRS has addressed this in a “stealth” but effective manner. The IRS updates its procedures for determinations, private letter rulings, and other matters at the beginning of each year. The new Revenue Procedure 2012-4 addresses procedures for matters under the jurisdiction of the Division Commissioner, Tax Exempt and Government Entities. This year’s procedure added a new type of determination letter that the Exempt Organizations Determinations office will issue. Section 7.05(14) adds a “government entity voluntary termination of Section 501(c)(3) recognition (must include documentation of tax-exempt status other than under Section 501(a)).” Thus, governmental entities with Section 501(c)(3) determinations now have a process for asking the IRS to remove this status.

    Governmental entities with Section 501(c)(3) determinations, particularly hospitals, should consider whether to take advantage of this new procedure.