IRS Increases Scrutiny of Hospital Charity Care

By Wendy S. Pearson, Of Counsel

Most hospital attorneys and finance officers are well aware that the Internal Revenue Service (IRS) has been closely examining hospital charity care for some time.

Current law requires hospitals to satisfy the community benefit standard in order to qualify as tax-exempt charities under section 501(c)(3). In 2006, under pressure from Congress, the IRS initiated two studies. The first, the Hospital Compliance Project (Hospital Project), was designed to determine whether nonprofit hospitals are indeed meeting their obligations to the communities they serve. The second, the "Compensation Survey" examined executive compensation practices and policies in hospitals and was aimed at halting excessive benefit transactions.

Now, with the recent publication of these two investigative reports and the release of a new Form 990 focusing on hospital reporting, the IRS has sent a clear signal to hospital executives and boards that they will be increasing hospital audits and compliance-related activities.

This memo summarizes the IRS' recent activity and recommends steps that hospitals can take in the face of the increased attention to these issues.

Hospital Compliance Project
The IRS released their interim report addressing the community benefit issues in July 2007. (For a copy of the reports, go to www.irs.gov/charities or contact our office for a copy.)

The Hospital Project asked approximately 500 hospitals to complete a questionnaire containing 81 questions. The study found that for most hospitals, uncompensated care is the largest category of their community benefit expenditures. (Other categories include newsletters, health screening, educational programs, and immunizations.) However, while the interim report summarizes the information reported by the hospitals, the agency has not released a complete analysis of the data because different reporting practices and definitions utilized by the respondents, along with unclear and incomplete responses, limited the usefulness of the study, according to the IRS.

Still, the report alarmed members of Congress. The Senate Finance Committee's ranking Minority member, Chuck Grassley, (R-Iowa) concluded that hospitals are doing very little charity care and suggested the following reforms:

(i) Requiring written charity policies for hospitals (which most Washington hospitals have - see www.wsha.org, "Leading the Way on Financial Assistance"),

(ii) requiring a minimum percentage of a hospital's operating expenses or revenue (e.g., 5%) to be used for charity care,

(iii) requiring hospitals to conduct periodic assessments of community need (as many hospitals already do),

(iv) limiting the rates nonprofit hospitals can charge indigent patients,

(v) recommending new board membership rules for joint ventures between for-profit and non-profit hospitals and limiting physician involvement on boards, and

(vi) proposing additional excise taxes and/or exempt status revocations for hospitals that do not satisfy the community benefit requirements.

More importantly, the Tax Exempt/Government Entities (TE/GE) division of IRS promised the Finance Committee, in its 2008 Audit Plan, to focus on tax-exempt compliance and increase hospital audits of the executive compensation and community benefit practices. Congress increased IRS' overall budget for 2008 by almost 7%, with $26.4 Million of that devoted to TE/GE audits and compliance. (See, Letter from IRS Commissioner Kevin Brown to Chuck Grassley (R-Iowa), June 28, 2007, 2007 Tax Notes Today Doc # 143-36.)

Form 990 Project
The Hospital Project team found considerable variation in how hospitals reported uncompensated care. In an effort to facilitate the reporting of community benefits, the Hospital Project team recommended that hospitals be required to file a separate schedule to Form 990. The Form 990 Project released a discussion draft of "Schedule H, Hospitals," as a separate reporting mechanism in June. The redesign of Form 990 is intended to enhance transparency, promote tax compliance, and minimize the burden on the filing organization. Lois G. Lerner, director of the IRS's Exempt Organizations division suggests, "Most organizations should not experience a change in burden. . . However, those with complicated compensation arrangements, related entity structures and activities that raise compliance concerns may have to spend more time providing meaningful information to the public." Unfortunately, the first two components of this description will apply to many hospital systems.

The new Form 990 includes:

• A summary page on which organizations must provide a snapshot of the organization's key financial, compensation, governance, and operational information.
  
  
• Governance information including the composition of the board, and certain other governance and financial statement practices.
  
  
• Schedules that focus on fundraising, compensation, tax exempt bonds, and non-cash charitable contributions.

The new Schedule H to Form 990 requires entities to report:

• Aggregate community benefits for all facilities, as well as information regarding billings, collections, and joint ventures.
  
  
• A list of facilities and a description of the type of services provided at each.
  
  
• Certain policies and activities in communities served by the organization.

The IRS is soliciting comments about the form, especially how well it achieves increased transparency of information and achieves its goal as a compliance tool. The comment period lasts until September 14, 2007. (Questions and comments should be e-mailed to the IRS at Form990Revision@irs.gov).

The IRS is specifically seeking comments about:

• The reporting of community benefit by hospitals, and the extent to which the Catholic Health Association's reporting format, on which Schedule H is based, should be modified.
  
  
• Defining "relatedness" for compensation and other purposes, including arrangements in joint ventures and with for-profit subsidiaries.
  
  
• Whether transition periods are necessary in order to ease the burden of implementing the new reporting requirements for certain form components (such as the tax-exempt bond schedule).
  
  
• Whether adequate consideration has been given to privacy concerns.

At the time we published this article, the IRS Web site included numerous comments and at least 42 hospitals have urged the IRS to delay implementation of the new Form 990 and Schedule H until 2010. Form letters sent by the hospitals call for the IRS to "include two expenses omitted from the agency's tally of community benefit: Medicare losses and bad debt." The letter also asks that "hospitals' reporting requirements be streamlined to eliminate questions that are burdensome and confusing and that fail to provide meaningful information to the community."

Executive Compensation Compliance Initiative Project
In 2004, the TE/GE division of IRS implemented the Executive Compensation Compliance Initiative (the Compensation Project), during which it examined certain organizations' Form 990s and related returns for tax years beginning in 2002, and conducted compliance checks and reviewed responses to questions on the Community Benefit survey that were directed toward executive compensation issues.

In a report that was released in March 2007, the compliance check results alarmed the Project team and resulted in some examinations. The Compensation Project team reported the following significant results:

• Compensation Issues
  The team found significant reporting errors and omissions regarding compensation paid to officers or other employees. Numerous respondents were referred for examination as a result of their answers to the compliance checks.
  
  
• Loans to Officers and Employees
  Of the 100 public charities reporting loans over $100,000 to officers, directors, trustees, and key employees, the IRS determined that 92 warranted follow-up, and, ultimately, 37 were referred for examination. As a result, IRS Exempt Organizations initiated 200 compliance checks and 50 additional single-issue examinations focusing on organizations with loans to executives.
  
  
• Section 4958
  Under Section 4958, public charities that use a three-pronged process (independent governing body, reliance on comparable data, and adequate documentation) when establishing compensation for a disqualified person create a rebuttable presumption that the compensation is appropriate. Only half of the reporting organizations attempted to satisfy all three prongs of the rebuttable presumption. Consequently, the Compensation Project team has proposed future initiatives that will focus on the correlation between satisfaction of the rebuttable presumption by an organization and the reasonableness of compensation paid to its disqualified persons.

Exempt hospitals can expect continued and increasing enforcement presence on this issue of executive compensation.

What Steps Can You Take Now to Ensure Compliance.
Given the heightened attention that both Congress and IRS will be paying to hospital charity care, as well as their executive compensation arrangements, we recommend that all hospitals seriously consider taking steps to review their internal systems. For some this may include substantiating, accounting for, reporting, and perhaps increasing their charitable activities. Immediate steps should include at least the following:

• Submit comments to the IRS before September 14, 2007 to the extent you have questions or concerns about the new Schedule H reporting requirements.
  
  
• Make sure you have an empowered, engaged, and independent Board of Directors and that your board governance policies and procedures are current.
  
  
• Make sure your charity care policy is up to date. For Washington hospitals, refer to www.wsha.org for a model policy.
  
  
• Review your internal systems for documenting the amount of charity care your hospital provides to ensure that they accurately capture all the care provided. Give careful consideration to how you define charity care. (Note: There is much debate over whether bad debt and contractual allowances should be included in this figure).
  
  
• Routinely review the results of your charity care efforts at the executive and board levels to ensure that they meet reasonable expectations.
  
  
• Review your internal policy for establishing compensation for executives, directors, officers and other key employees. Ensure that you take full advantage of the presumption of reasonableness by adopting and implementing all three steps outlined above and maintain adequate documentation. Be sure that your review of individual compensation includes all forms of compensation to an individual. Avoid making loans to officers, board members and other insiders.

Finally, please feel free to contact Wendy Pearson at 206-622-5511, with any questions you may have about the new Form 990 or Schedule H.