Preserving hospitals' tax-exempt status.

Exemptions from income, property, sales and other taxes enable many not-for-profit organizations (NPOs) to survive and even prosper in markets known for high costs and steep competition. Despite certain drawbacks, most NPOs find the advantages of tax-exempt status far outweigh the disadvantages. Yet in the last decade, NPOs (particularly hospitals) have faced numerous challenges, including tougher cost-containment policies, increased government scrutiny of their business activities, greater recordkeeping and regulatory requirements, more competition from the proprietary sector and even lost exemptions. NPOs may face the stiffest challenges to their tax exemptions and benefits ever as governments seek to raise revenues and limit their commercial activities.

This article examines the latest and most likely challenges that may threaten NPOs' tax exemptions (specifically those of Internal Revenue Code section 501(c)(3) organizations, which include charities, churches, colleges, universities and scientific entities). CPAs will find this information useful in helping to direct their NPO clients' charitable focus and strengthen the defense of their exempt purposes.

QUALIFYING UNDER SECTION 501(C)(3)

To qualify, an NPO must be both organized and operated exclusively for one or more exempt purposes (religious, charitable, educational, etc.) specified in the IRC. Since the code does not expressly mention hospitals or health care services, hospitals must demonstrate they are operated for charitable purposes to qualify--for example, by having outside community leaders on boards of trustees, providing medical services to patients able to pay (including government health care recipients) and operating, emergency rooms open to all (including those unable to pay).

NPOs are not considered charitable if they are operated for the private benefit of physicians and other providers or if any part of their net earnings benefits private individuals. (The determination does not include reasonable compensation for services performed.) In addition, organizations' assets must be restricted for exempt purposes rather than private interests. Interestingly, the Internal Revenue Service held in revenue ruling 69-545 that hospitals do not have to provide free or below-cost care (other than those provided through open emergency rooms) to the indigent to meet the charitable purpose requirement. However, recent actions by several states and proposed legislation in Congress appear to be directly in conflict with this position.

PRIMARY RISK AREAS

Despite strong advantages, there are certain risks associated with section 501(c)(3) status. Given the current legislative environment, NPOs must be aware of potential tax liabilities and even challenges to their tax exemptions.

* Inurement of benefit to private individuals. Potential inurement areas include salaries and employee benefits, employee recruitment programs, joint ventures or rental agreements with for-profit staff or affiliates and loans or loan guarantees. The IRS has increased its scrutiny of these areas through audits of hospitals and other NPOs. Over 230 hospitals have been audited since 1988, with more audits under way. The IRS issued examination guidelines for hospital audits in March 1992 that focus on inurement issues, and in May 1992 it identified certain partnerships and joint ventures involving gross or net revenue allocations to for-profit partners that violate the inurement-of-benefits prohibition.

* Unrelated business income tax (UBIT). NPOs may engage in unrelated business activities for profit without losing their exempt status if the activities are not a substantial part of their operations, do not become a principal purpose and do not result in private inurement of benefits. UBIT is imposed on such activities' taxable income. The most recent IRS data (for 1987) show that about 2.5% of NPOs reported $2.5 billion of gross income from unrelated activities, with section 501(c)(3) organizations accounting for about one-fourth of the filings and nearly half the total unrelated business income. The 2.5% figure probably does not represent the full scope of unrelated activities, as these data were gathered before the recent wave of hospital audits, which have resulted in greater UBIT compliance and reporting.

The primary risk of engaging in such activities centers around their potential tax liabilities rather than loss of exemption, although the IRS can revoke an exemption if the unrelated business activities become an NPO's principal purpose. As a result of its audit program, the IRS found a 40% non-compliance rate with UBIT filings. The key issues appear to be whether an NPO engages in unfair competition with for-profit businesses, whether private benefits inure to physicians or employees and whether the activity is in direct conflict with the NPO's charitable purpose.

NPOs and their CPAs should verify compliance with all required reporting requirements and keep abreast of ongoing IRS examinations, congressional hearings and proposed legislation. The IRS is conducting a coordinated examination program to audit NPOs and has become much more informed of their unrelated activities through audits and increased reporting requirements for forms 990. Although there have been some minor changes to the UBIT laws, further limitations on NPOs' activities are likely.

* Extent of charitable activities. Much recent legislation has dealt with the extent of NPOs' charitable activities, particularly at the state level, where lack of sufficient charity care has cost some hospitals their property tax exemptions. Although each state provides property tax exemptions to charitable organizations, institutions with nonexempt or commercial activities may find themselves subject to partial (or full) property taxes.

The main thrust of state legislation and court decisions has centered around whether NPOs provide enough social-charitable benefits to justify the value of tax benefits received. States such as Tennessee, Utah, Pennsylvania, Virginia and Vermont have recently revoked hospital exemptions or passed legislation to impose property taxes on unrelated business property when the amount of free health care provided is not adequate. Since property taxes often are material, each NPO must first ensure it complies with state laws. Documenting free care and other benefits provided is essential. The NPO and its CPA should then monitor the state tax environment to prepare for potential challenges or additional fees.

The federal government has addressed NPOs' charitable operations in two main ways.

1. The Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA) requires hospitals with emergency rooms participating in Medicare to treat all patients regardless of ability to pay, while 1990 COBRA regulations further prohibit "patient dumping" in general (that is, transferring indigent patients to public hospitals). In essence, COBRA requires hospitals to adhere to the community benefit rule in revenue ruling 69-545. Hospitals must actively comply with COBRA by adopting and enforcing a policy, posting signs stating their compliance, treating and stabilizing emergency patients before transfer, keeping records of patient transfers and maintaining a list of physicians on call for charity care. Failure to comply with COBRA may result in large fines, possible expulsion from Medicare and even loss of the section 501(c)(3) exemption.

2. Legislative proposals and ongoing congressional hearings may determine not-for-profit hospitals' charity care responsibilities more formally. Legislative proposals have addressed whether such hospitals operate to the extent of their financial abilities for the benefit of those unable to pay. Proposed changes include distinguishing charity care from bad debts, providing charity care and community benefits equal to a specified percentage of benefits received from tax exemptions and requiring joint ventures with for-profit entities to have community benefits. Future legislation is likely to include some version of these and other proposals. Hospitals and other NPOs are well advised to document and plan for their charity care and their community benefits to maximize the protection of federal and state tax exemptions.

* Prohibition on political activities. Section 501(c)(3) organizations are prohibited from engaging directly or indirectly in any campaign for or against any candidate for public office. Participating in political activities may cause NPOs to lose their exemptions as well as to be subject to excise taxes on their political expenditures. Separate penalties also may be imposed on NPO management. The IRS allows NPOs to participate in educational activities relating to candidates as long as the activities do not endorse or oppose a candidate. In a 1992 release, the IRS reiterated its warning that efforts beyond mere education can cause NPOs t lose their exemptions.

NPOs are allowed to engage i limited (not substantial) lobbying activities without losing their exemptions, including promoting, op posing or introducing legislation a all government levels and influencing legislation through attempts to affect public opinion (grass-roots lobbying). To maintain exempt status, section 501(c)(3) organizations must elect to participate in lobbying activities and adhere to the statutory ceiling amounts. The maximum expenditures are $1 million for lobbying activities and $250,000 for grass-roots lobbying. A 25% excise tax is imposed on excess lobbying expenditures, and exemptions are lost if NPOs' lobbying expenditures exceed 150% of the allowable amounts over (in most cases) a four-year period.

* Independent contractors. One other hot issue at the IRS is the classification of workers as independent contractors versus employees. Independent contractors typically are paid on a contractual or hourly basis and are responsible for the payment and reporting of their own employment and income taxes. In addition, they generally do not receive health and other fringe benefits provided to employees. Because of cost-containment factors and high benefit costs, not-for-profit employers may improperly classify individuals as contractors rather than employees. The IRS imposes stiff penalties on NPOs that classify employees as independent contractors to lower employment taxes and benefit costs.

PROTECTING TAX-EXEMPT STATUS

Although the risk of losing tax-exempt status probably is small, there are several steps NPOs can take to strengthen their position, prepare for audits and reduce future assessments. CPAs can provide valuable assistance in these areas.

* Mission statement. Every NPO should have a clearly defined mission statement detailing its purposes, activities and goals. Much of this information is reported to the IRS on written applications for exempt status, but many NPOs received their exemptions years ago and were not subject to more formal evaluations of their activities and purposes. Further, many NPOs engage in additional activities beyond their original scope and may have failed to notify the IRS of their expanded purposes (a requirement to keep their exempt status). Adopting a new mission statement or modifying an existing one has become more important given state governments' current emphasis on NPOs' charitable activities.

* Defining charitable activities. Based on the recent direction of federal and state governments, it appears NPOs need to better define and document the extent of their charitable activities. In the 1980s, NPOs concentrated on diversifying and on developing commercial activities, often through reorganizations. In some cases, however, the pendulum appears to have swung too far toward commercialism, overshadowing the exempt purposes for which some entities were formed. These NPOS ares most at risk of losing their exemptions. Yet many more are vulnerable, especially at the state level.

To strengthen the defense of their exemptions, NPOs should establish (or revise) their policies and criteria for determining charity care and community benefits. For example, services performed for patients meeting the criteria for charity care should not be recorded as revenues. NPOs should document the social and community benefits (preferably in monetary terms) generated by joint ventures. Hospitals need to identify the amount of charity care they provide and to review their collection policies for needy patients. Audits of Providers of Health Care Services, published by the American Institute of CPAs, also recommends establishing a policy to distinguish between charity care and bad debts.

As a result of state law changes and federal proposals, NPOs and their CPAs also may want to quantify the approximate value of the benefits they receive from their exemptions and compare them with the dollar value of the benefits they give the public. If the amount of benefits given is low in relation to the tax benefits received, the NPO may need to broaden its charitable policy in the future.

* Documentation. Proper documentation remains one of the most important defenses organizations can have. Contracts and joint ventures should be reviewed for inurement potential (using the IRS standard), with necessary modifications made to the extent possible. In response to greater public sensitivity to excessive compensation, key individuals' wages and benefits should be reviewed for reasonableness and compared with those of similar institutions, with material variances explained. Potential conflicts of interest and their resolution should be identified and documented. The nature, purpose and amount of all lobbying activities also should be documented. Loans to individuals or affiliates should be in writing and interest should be charged at prevailing rates. Income from unrelated business activities should be reported on forms 990-T, even if the activities result in taxable losses. Finally, CPAs and entities' financial managers should be familiar with the IRS's new audit guidelines for such organizations and be prepared for examinations in the key risk areas.

EMPHASIZING THE TRUE PURPOSE

NPOs will continue to face many challenges. They can best protect their tax exemptions and related benefits in the years ahead by understanding the legislative environments in which they operate, redefining their missions and charitable focus and documenting the accomplishment of their exempt functions. The bottom line remains emphasizing the exempt purposes for which they were created rather than commercializing nontraditional activities.

Barbara A. Theisen, CPA, associate professor of accounting, and

Sandra Pelfry, CPA, assistant professor of accounting, Oakland University, Rocheste, Michigan, offer a list of potential trouble spots CPAs can watch for when their health care clients are concerned about retaining the privileges of tax exemption.

EXECUTIVE SUMMARY

* DESPITE THE BENEFITS not-for-profit organizations (NPOs) enjoy, such entities have faced numerous challenges in the last decade, including loss of tax benefits and exemptions.

* INCREASED IRS AND congressional scrutiny has resulted in additional taxes for many NPOs, especially hospitals.

* SEVERAL STATES impose property taxes and service fees on NPOs that do not engage in an adequate level of charitable or community activities.

* ADOPTION OF A detailed mission statement and a charitable-community benefit policy can help to protect exemptions and related benefits.

* CPAs CAN PLAY an important role in helping to direct their NPO clients' charitable focus and protecting their tax benefits and exemptions.