Today's issues in tax exemption.

Maintaining tax-exempt status has been a constant concern for not-for-profit organizations of every description, and long-term care facilities are no exception. That concern is intensifying for several reasons: (1) competition with for-profit providers is heating up in these increasingly cost-conscious days; (2)state and Federal governments are under intense pressure on the taxation and deficit fronts; and (3)very profit-oriented managed care firms are looking to hook up with not-for-profit providers in various networking ventures. Not-for-profits must submit themselves to self-examination perhaps as never before.

Nursing Homes Managing Editor Laura Bruck posed some of the questions worth asking to tax attorneys expert in not-for-profit issues: Herman Rosenthal, Esq., Joseph Truhe, Jr., Esq., and Bill Davidow, Esq., partners in the Baltimore, MD. law firm of Whiteford, Taylor & Preston LLP. Their answers combined reassurance with some strong suggestions for focused attention.

Bruck: What, if any, are the present challenges to the tax-exempt status of long-term care not-for-profits?

Rosenthal: In general terms, the tax-exempt status of not-for-profits has come under review in the past by Congress, particularly four or five years ago when there were several Congressional hearings. The hearings didn't focus on long-term care per se, but were instead forums for general inquiries about overall issues related to not-for-profit status in general.

While this generated a fair amount of interest, particularly on the part of not-for-profits, I don't know that it really led to a great deal other than a general sense on the part of the IRS that they should be reviewing applications for exempt status and pursuing some of the more egregious instances of noncompliance with a closer eye. But in general, I don't think this has the same kind of momentum it had a few years ago.

In the interim, however, the IRS seems to be advocating for so-called intermediate sanctions(*), which, as the name suggests, would result in something in between simply yanking 501/C3 status and declaring a facility in compliance. That "something" might be a tax paid by the facility while they keep their tax exempt status.

In terms of long-term care, intermediate sanctions would probably be a positive development. The IRS would probably feel they had the ability to go in and start examining not-for-profits more closely, devoting their audit resources not just to the most egregious cases but also to general compliance issues. The better run not-for-profits would continue to maintain their exempt status, and those that aren't as careful as they should be might face these intermediate sanctions.

The IRS has also been in the process of issuing revenue rulings in the health care area that deal with, among other things, not-for-profit status and maintaining that status. The IRS is now addressing issues in these revenue rulings, particularly with respect to physician recruitment and other related issues. The IRS has issued, for internal purposes, a book dealing with the tax exempt status of health care organizations that is used primarily for training and auditing purposes. It has also developed audit programs for hospitals and with respect to tax exempt bonds.

So while it's clear that the IRS is stepping up its activities in this area and in the area of enforcement as well, those issues are related primarily to the fundamentals of tax exemption, rather than the whole range of specific issues they might pick up on if intermediate sanctions were enacted.

It's important to understand that there will still be the normal kinds of audit issues that arise here and there. The independent contractor versus employee question is one example, and we shouldn't lose sight of this. So the mere fact that the IRS isn't necessarily in there checking on the exempt status of not-for-profits doesn't mean they're not going to be looking for other types of issues.

Truhe: Going back to what was going on a few years ago during the Congressional hearings, the press reported, for instance, that magazine publishers were questioning the tax-exempt status of National Geographic, wondering why the magazine should have a competitive advantage when they were in the same business and generating the same types of advertising revenue as the entities without tax exemption.

The spillover effect on hospitals came about through observations that hospitals, which were once genuine public charities, now provide very little free care. The same applies to nursing homes, but to a lesser extent. So, like the magazine publishers, the proprietary hospitals were essentially saying, "The not-for-profits are in exactly the same business we're in, with the only difference being that they don't pay dividends to shareholders. Why should they have exempt status just because of that?"

What this led to, on the part of the boards of some not-for-profit institutions, was some self-examination with respect to the degree to which they were really serving their communities. In other words, it helped to put their eye back on their charitable mission which, of course, is certainly a good thing. This, then, became the focus of a number of these sessions in which tax exemption was being discussed.

Rosenthal: I think it's true that there has been some internal evaluation on the part of not-for-profits. But I want to emphasize that the standards under which the IRS reviews exempt status have not changed. In other words, the standards for establishing the exempt status of hospitals, CCRCs or nursing homes remain the same and I don't think the IRS could, at this point, arbitrarily change them without some sort of legislation. So, that's the good news. There may be new interpretations of existing requirements, but the fundamental requirements have remained the same.

Bruck: What does the IRS look for to determine whether or not a long-term care facility is in compliance with 501/C3 requirements?

Davidow: Basically, the underpinning of exemption for a continuing care or skilled nursing facility is the same as it is for hospitals - promotion of health in the community - albeit a special, but relatively broad, segment of the community. But there are certain benchmarks that the IRS looks for, i.e., in the nursing home setting, they're looking for a charitable element, e.g., the policy and practice of supporting residents after they can no longer pay for care.

Rosenthal: In fact, there are specific IRS-issued revenue rulings in connection with life care facilities that state exactly what Bill is saying and set out the standards a life care facility must meet in order to be exempt. Continuing to provide care, within the reasonable means of the facility, is one of those requirements and comes out of a 1972 revenue ruling.

Truhe: During an audit, the IRS looks for anything that might suggest that the institution has suddenly changed its actual operating policies, e.g., now taking only private pay residents when it used to take Medicare and Medicaid, or signing a number of insider contracts in which the physicians on the board now have sweetheart deals as medical directors - in other words, operating to the benefit of insiders.

Bruck: How do not-for-prof-its go about meeting the requirements of the community benefit test?

Davidow: There's no precise formula. The IRS essentially wants to see two things - that the community is represented on the board, i.e., it's not a board of so-called insiders, and that the community has access in some way, shape or form to the services provided. The latter is somewhat difficult to quantify.

Rosenthal: Access, in part, is measured by the extent to which the facility is available to a large segment of the community. It's a bit of a subjective standard, but it can be measured in part by determining if the facility is operating at the lowest cost possible to the community, so that its services are generally available to a wide segment of that community.

Truhe: Typically, that requires some amount of absolutely free care, but, at a minimum, it requires that the facility accept Medicare and Medicaid, without which it would certainly be difficult to demonstrate access.

Rosenthal: Again, that's going to vary by the type of facility. That clearly isn't a requirement with a CCRC. As long as a life care community is providing care to the elderly and also has a policy of maintaining residents when they're no longer able to afford care - within the reasonable means of the community - the CCRC will be satisfying the requirements for tax exemption under the 1972 ruling. The 1979 ruling also requires that the CCRC be reasonably available to the community as well. That doesn't mean it has to be available to every individual, but reasonably available to a wide segment of the community.

Truhe: In the CCRC, the financial picture is different because you're talking about affording the residential aspect of care as well. This means the IRS requires them to operate at the lowest feasible cost to provide access to that aspect of care and to keep residents when they run out of funds.

Bruck: What are the potential benefits and/or liabilities that not-for-profits should keep in mind with respect to their tax-exempt status and the possibility of involvement with a managed care organization or integrated delivery system?

Truhe: It doesn't really change the rules. What it does is create the need to pay close attention to whether or not you're losing your focus. As I said earlier, institutions that were going along and naively assuming they were operating charitably woke up, did some self-examination and found, in many cases, that they weren't doing as much for the community as they thought they were.

The potential "danger" of hooking up with integrated delivery systems is that the not-for-profit will get taken up in the "mission" of becoming part of a mega-system and will lose their focus on the community and their mission. It's not that there's any rule against signing a managed care contract that directs patients to a network of organized providers, it's just important to be careful that you don't sign contracts with the purpose of creating profit in another entity at the expense of one of the non-profit members of the group. In other words, you don't want to find yourself in a situation where you're trying to maximize profits at the system level because you have an ownership interest in it. In short, you need to be careful about whose mission is being advanced.

Bruck: Do you envision requirements for tax-exempt status becoming more stringent?

Rosenthal: I do think there will be continued pressure in terms of reviewing applications for exempt status and for continued compliance. Certainly the efforts of the IRS are picking up in this area. That's been going on for the last several years and I suspect it's going to continue. Again, there's a separate question as to whether the standards that not-for-profits have to meet will change, and I don't know that that's really on the horizon.

I do think the dramatic changes occurring in the health care industry are going to require a constant review of the fundamentals that a not-for-profit has to meet.

Davidow: There is another issue - more political than legal - and that is the question of whether or not hospitals, nursing homes and CCRCs should be exempt of tax in the first place. This comes up relatively frequently in Congress. So far, these institutions have maintained their exemptions, but there's always the possibility that the day will come when neither hospitals nor nursing homes are exempt at all. There are a lot of for-profit competitors that continually put this issue on the table. While this is likely to be a political challenge in the future, it is difficult to predict whether the challenge will be successful.

Truhe: All of this really creates a system of checks and balances. A couple of things happen when this political debate arises in these legislative forums. You have the for-profits saying that they're doing the same thing the not-for-profits are doing and the not-for-profits counter by saying that they focus on quality and, because they don't have to satisfy shareholders, they can focus on their mission.

The check and balance that's created is that not-for-profits can't charge so much in the pursuit of quality that proprietary entities become less expensive, and for-profits can't sacrifice quality for the sake of cost to the point where no one will buy their services because the not-for-profits have superior quality. So, in addition to ordinary market forces that would exist in an exclusively proprietary market environment, you have an additional check and balance because you have a complete segment of the market that is mission-oriented and not-for-profit. Legislators and other bodies think that's healthy.

The other thing to consider, of course, is that if we didn't have tax-exempt status for not-for-profit long-term care providers, the dollars that go to subsidize care in not-for-profit facilities would disappear, meaning that the care that isn't being provided by proprietary entities wouldn't be provided at all. Ultimately, the government would have to pick up a bigger share of the tab and taxes would have to be raised. It's similar to the argument for tax-exempt status for parochial schools.

Bruck: How should not-for-profits go about protecting their tax-exempt status?

Rosenthal: There are a couple of ways to answer that. On an individual basis, with respect to the Federal Internal Revenue Code, they need to keep in mind the basis on which they originally got their exempt status and to analyze new opportunities that may come along - whether a joint venture or managed care arrangement - in light of how they may or may not affect compliance with those requirements. Obviously, keeping up to date on various IRS pronouncements is important as well.

For not-for-profits in the aggregate, as Bill was suggesting, maintaining tax- exempt status is more a political than a legal issue. But it's also important to note that, while we've been focusing on the Federal side, there is a state arena as well and a whole variety of state taxes and various exemptions that are available for not-for-profits. The states have been fairly aggressive in trying to limit the extent to which, for example, property tax exemptions can be claimed by not-for-profits.

Truhe: One way of looking at it is that all the things we've been saying that are more or less hypothetical at the Federal level are very real at the state level when you're talking about property taxes - not just for CCRCs, but for hospitals and nursing homes. It's entirely possible for the state assessor to ask themselves why they're exempting a property when they don't appear to be providing any charity to the community.

What not-for-profits need to do is educate not just state but local elected officials and administrative agencies as to what it is about their operation that is charitable. They also have to educate those same people as to the fiscal implications for the state budget and the quality of life in the state and local arena of changing the exemption situation.

When you have states with tight budgets, it's very politically attractive for politicians to go after tax exemption. Averting these types of political tendencies takes a great deal of hard work on the part of trade associations and individual institutions. Providers that have local delegates need to get their state representatives and state senators into their facilities to tour and be educated as to the kind of services that are being provided. Then, providers need to make the fiscal argument for the care being delivered, affordable housing being provided, the health status of the community, the state Medicaid budget, and all of the fiscal ramifications of this. Legislators will be more likely to come to the conclusion that the idea of taxing that particular not-for-profit isn't such a good one after all.

Community Benefit Requirements Explained

Have some questions about the community benefit requirements for tax exemption? AAHSA is providing some answers in a new video tape being distributed free of charge to AAHSA members.

The 23-minute video, Reaffirming Your Commitment to Community: The Social Accountability Program for Non-For-Profit Homes and Services for the Aging, was developed to help AAHSA members to demonstrate their contributions to their communities. The video provides tools to assist the not-for-profit provider in assessing community needs, developing community service plans and reporting and evaluating community service.

For more information, call Robert Greenwood at AAHSA headquarters, 202-508-9475.

* At press time Congress passed the intermediate sanctions bill.