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IRS determinations present challenges to physician compensation mechanisms.

Section 501(c)(3) of the Internal Revenue Code provides exemption from federal income tax to organizations organized and operated exclusively for charitable purposes as long as no part of the organization's net earnings of inure to the benefit of any private shareholder or individual. The inurement proscription of Section 501(c)(3) of the Code applies to organization "insiders" who have a personal and private interest in the activities of the organization. The IRS has adopted the broad view that the term "insider" includes physicians on the staff of the taxexempt hospital.

If a tax-exempt hospital violates the private inurement prohibition, its tax-exempt status is subject to revocation by the IRS. Moreover, there is no de minimis exception to the inurement prohibitions. Consequently, physician-hospital relationships must be closely evaluated to ensure that there is no prohibited inurement present in any of the contractual arrangements between these groups.

Additionally, tax-exempt entities are subject to the restriction that an entity is not organized and operated exclusively for exempt purposes unless it serves a public rather than a private interest. As with the inurement proscription, if a tax-exempt hospital violates the private benefit prohibitions of the Code, its tax-exempt status is subject to revocation. The private benefit prohibition differs from the private inurement prohibition because it is not limited to insiders. In addition, unlike the private inurement prohibition, which is an absolute prohibition, the private benefit prohibition does not apply where the benefit conferred is only incidental to the public benefit conferred.

As the health care industry has become more competitive, not-for-profit hospitals and other health care employers have developed strategies to retain the expertise of health care professionals in their communities. The IRS has looked at all of the facts and circumstances of these compensation arrangements in order to determine whether a payment program resulted in impermissible private inurement to physician participants. The IRS has maintained that variables such as the expertise of a physician, the location of the hospital (e.g., rural versus urban), and the method and amount of compensation are important in order to determine whether inurement exists.

In the past, the IRS has approved financial arrangements between not-for-profit hospitals and physicians that provided creative compensation incentives to the physician participants. For example, the IRS issued a number of private letter rulings to taxpayers that sanctioned a hospital's sale of part of its operations revenue stream to a joint venture between the hospital and medical staff physicians. In addition, the IRS has sanctioned a hospital's payment of a percentage of adjusted gross revenues from its radiology department to a hospital-based radiologist in exchange for his services. Both of these compensation mechanisms were beneficial to the tax-exempt hospital participant because they rewarded efficient utilization of hospital resources and ensured a steady patient stream to the hospital. However, recent rulings and communications from the IRS indicate that taxpayers may not rely on these prior determinations in fashioning compensation opportunities for physicians.

GCM 39862

In General Counsel Memorandum 39862, the IRS reviewed three private letter rulings that had approved specific hospital-physician joint ventures involving the sale of part of hospitals' revenue streams to physician participants. In all of the transactions, the revenue streams were discounted to present value after fair market value was established. The IRS determined that the hospital participants jeopardized their tax-exempt status in these ventures for three reasons.

First, the transactions caused the hospitals' earnings to inure to the benefit of private individuals because they constituted a sale or gift to physician-investors of an ownership interest in the net profits of the hospitals. The IRS found this practice indistinguishable from the payment of stock dividends. Second, the IRS stated that the private benefit stemming from the transactions could not be considered incidental to the public benefits achieved. The IRS' view was that the expected public benefits, such as enhanced hospital financial health or greater efficiency through increased utilization, did not necessarily constitute a permissible public benefit. Finally, the IRS intimated that the transactions may have violated federal law, in particular the rules relating te Medicare "anti-kickback" statutes. The General Counsel's office urged revocation of earlier rulings that had approved similar transactions.

Audit Guidelines

In March 1992, the IRS issued revised hospital audit guidelines for use by agents conducting reviews of not-forprofit hospital systems. The guidelines were issued as a result of congressional scrutiny of not-for-profit hospitals in an effort to determine whether they provided a genuine benefit to their communities commensurate with their tax-exempt status. For the first time, the IRS has indicated that,depending on the results of these comprehensive audits, it may revoke the tax-exempt status of a hospital.

The audit guidelines question compensation mechanisms that the IRS had regarded with favor in the past. For example, the IRS had approved a hospital's payment of a percentage of adjusted gross revenues from its radiology department to a hospital-based radiologist in exchange for his services. Unlike situations where a physician and a hospital share the revenue stream from a practice or department, this form of compensation did not involve a sharing of profits between a hospital and a private individual because the hospital charged the patient separately for the physician's services and for use of the hospital's facilities. The Audit Guidelines, however, state that "[t]his type of arrangement must be closely scrutinized for potential incuremont."


These recent regulatory interpretations by the IRS do not forbid all types of hospital joint venture arrangements with physicians. Nor do the IRS' activities prohibit compensation plans that provide reasonable incentives to physician employees. Notably, the IRS pronouncements are designed to provide guidance for IRS staff members and have questionable legal standing. The conservative views of the IRS will not necessarily be followed by courts charged with applying the Code to tax-exempt hospital activities. However, careful study of these interpretations can help a hospital formulate new arrangements or revise existing ones to minimize the risk to its tax-exempt status while simultaneously allowing it to participate in progressive compensation plans. In the meantime, the health law bar is awaiting the expected release of another GCM that will focus on physician recruitment activities by tax-exempt entities.
COPYRIGHT 1992 American College of Physician Executives
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Article Details
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Title Annotation:Health Law
Author:Reaves, Cynthia F.
Publication:Physician Executive
Date:Sep 1, 1992
Previous Article:Sometimes we're our own worst enemies.
Next Article:Confrontation has to be planned and timed.

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