IRS guidelines for audits of tax-exempt hospitals.

Concerned that tax-exempt hospitals have become more interested in big business than in charity care, the IRS has increased its audit activity in the health care area. Based on prior audits, the Service has developed a road map on health care.

Several areas in particular have been highlighted in expanded audit guidelines and will be the focus of IRS examiners. The agents will be concentrating on measuring the community benefit standard; finding evidence of private inurement (including unreasonable compensation) and private benefit; analyzing joint ventures and other financial matters; and determining whether independent contractors are properly classified. There is particular emphasis on arrangements with physicians and compliance with disclosure and reporting requirements.

A hospital must meet a community benefit standard to be exempt under Sec. 501(c)(3). To determine whether a sufficient community benefit is provided by a particular hospital, IRS examiners have been given specific instructions to review - the governing board to ascertain its independence; - the admissions policy for new staff physicians; - whether the emergency room is open to all, regardless of ability to pay; and - whether a reasonable number of Medicaid patients receive care.

While the concepts of private inurement and private benefit are similar, they differ in two significant ways. A small amount of inurement to insiders may allow the Service to challenge a hospital's exempt status, while a benefit to a private individual, whether or not an insider, must be more than incidental to jeopardize a hospital's exemption. A finding of unreasonable compensation can be tantamount to a finding of private inurement.

The guidelines now specifically classify all physicians as insiders subject to the private inurement prohibition. Agents are instructed to look at free or discounted services, benefits or outright cash payment to insiders, as well as unfunded compensation agreements and payments from taxable subsidiaries, when looking at the reasonableness of compensation. Acquisition of physician practices will be closely scrutinized.

Joint ventures will also be scrutinized carefully to determine if an arrangement truly furthers the hospital's exempt purposes. Generally, joint ventures are entered into to provide health care services such as diagnostic and outpatient services. The guidelines reaffirm the Service's position generally prohibiting private benefit, private inurement, unreasonable compensation and anti-kickback violations. Furthermore, the guidelines instruct field agents to seek IRS National Office technical advice in any situation in which a hospital transfers something of value for a referral of patients or if there is an issue of excess compensation.

All income and expenditure accounts will be examined to determine if nonexempt purposes, inurement, serving of private interests or unrelated business income are present. The guidelines also require that both cash and noncash contributions be reviewed carefully for reporting compliance and proper accounting treatment.

A copy of the hospital's Form 990, Return of Organization Exempt from Income Tax, which is made available to the public by the institution, will also be reviewed. If the information is incomplete or compensation information is not fully disclosed, IRS agents are instructed to assess penalties.

The Service is directing its agents to look at arrangements in which the hospital pays the personal or business expenses of doctors and the income is not properly reflected as wages. The guidelines give the agents specific factors (such as the provision of malpractice insurance) which, if present, support the reclassification of independent contractors as employees.

These new guidelines give IRS field agents new tools to conduct comprehensive reviews of hospital policies and practices from a community benefit standard to a complete financial analysis of the way business is conducted. These guidelines are not unlike those developed a decade ago in the program to examine private schools nationwide, and are a clear indication that the Service is no longer just talking compliance but is putting in place a national compliance program for the hospital industry.