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Taxation and health care.

IRS releases new audit guidelines The IRS has released new guidelines (the Manual)for tax-exempt hospitals aimed at instructing revenue agents on how to identify situations that might affect the hospitals' tax exemptions. Though the immediate focus of the guidelines is this tax-exempt status, substantial attention is devoted to the relationship between a hospital and its physician staff.

Tax exemption issues

To qualify as exempt under Sec. 501(c)(3), a hospital must meet a community benefit standard. Among the factors comprising this standard are (1) a governing board comprised of "prominent civic leaders," rather than hospital administrators and physicians, (2) an open medical staff admission policy, consistent with size and operations; (3) operation of a full-time emergency room available to all, regardless of ability to pay, and (4) provision of nonemergency care to those able to pay, including Medicare and Medicaid recipients.

Reflecting the Service's increasing focus on physician relationships, the Manual promptly launches into a discussion of medical staff privileges. Agents are advised to review staff qualification requirements in the bylaws, looking for evidence of a closed staff. Agents are further advised to review census data to see if use of the hospital facilities is limited to certain physicians. Reference is also made throughout the Manual to the Fraud and Abuse Regulations issued by the Office of the Inspector General (OIG) of Health and Human Services.

Of particular import to exempt entities is the private inurement issue. The first example cited is excessive compensation, followed by excessive rent and inadequately secured loans. Inurement occurs when insiders receive any of the benefit of a hospital's exempt status. The Manual notes "that even a minimal amount of inurement results in disqualification for exempt status." It further states that physicians are considered to be insiders with respect to this inurement prohibition. Particular attention is to be paid to contracts with physicians who serve as department heads or board members.

Examples of inurement

Unreasonable compensation:

Whether the compensation paid an individual is reasonable must be based on the facts and circumstances of each situation; there are no hard and fast rules. (For an indepth discussion of the issue of reasonable compensation for professionals and planning for an IRS exam, see Dietrich, "Unreasonable Compensation For Employee-Stockholders of a Professional Corporation," TTA, Mar. 1992, at 178.1 The Manual cites a variety of areas of concern for agents to examine.

Potential unreasonable compensation issues cited by the Service include recruiting incentives, below-market leases or loans, and the purchase of a physician's practice with subsequent employment of the physician in the same practice. Private practice income guarantees and assistance with relocation expenses are also mentioned.

The Manual discusses a number of factors to be considered in evaluating each potential area of unreasonable compensation. Of particular note are those applicable to loans. The Manual specifies that a reasonable rate of interest would generally be prime plus 1% or 9.%. Many organizations may be using the applicable Federal rate (AFR) for the loan term, which would generally be less than the Manual guideline. Further, it suggests that any difference between the rate offered and that commercially available should be treated as compensation. It is also suggested that loans require board approval.

Private practice income guarantees "may be acceptable for a one- or two-year period" if the community serviced by the hospital requires the new physician's services. It is unclear whether the income guarantees offered by many faculty group practice plans to new physicians would be subject to the same standard.

A separate portion of the Manual discusses in detail the use of unfunded deferred compensation plans by hospitals and calls attention to plans providing for amounts in excess of the Sec. 457 limit of $7,500. Agents are advised to refer plans created after Jan. 1, 1987 to the National Office for evaluation of their propriety. This is an apparent reference to the requirement that such amounts must be currently included in income if not covered by the grandfather provisions of the Tax Reform Act of 1986. It may also be an attempt to identify arrangements subject to the penalty tax of Sec. 402(b)(2).

Joint ventures: The Manual describes the range of potential structures used in joint ventures between tax-exempt hospitals and other parties. It repeats the Health and Human Services Fraud and Abuse criteria, including such factors as encouragement of referrals by physician-investors, nontransferability of interests, disproportionate or nominal capital investments by physicians and "extraordinary" returns on the investment.

The Manual directs the revenue agent's attention to GCM 39862, in which the IRS advised that a sale of a hospital department revenue stream to a group of physician investors threatened the hospital's exempt status. Finally, it advises a search for informal arrangements under which hospitals transfer something of value to "physician group practices or clinics" in exchange for referrals. Financial analysis: Agents are advised to reconcile the exempt organization's tax return (Form 990) to financial statements prepared by the independent CPA. Also recommended are reviews of the CPA's workpapers and any management letters issued in accordance with generally accepted auditing standards. Employment tax issues are to be addressed as a routine part of each audit.


A reading of this newly revised Audit Manual indicates that the IRS has gained substantial expertise in the hospital and physician area. This experience has been gained, in part, at the expense of the large numbers of hospitals already audited. Of even greater concern is the potential for increasing cooperation between, or even joint audits conducted by, the Service and the OIG.

The focus of the hospital audit guidelines on relationships with physicians should be viewed with concern. There is an obvious predisposition on the part of governmental agencies towards negative views of physicians, and these views are also politically popular. The threat of revocation of exempt status in the event of a finding of nominal inurement should not be underestimated or ignored.

Despite the availability of various defenses in court proceedings, the cost of defending against an IRS challenge should be weighed in the planning process. A multi-pronged attack by the OIG (the criminal ramifications) and the Service {exempt status and employment tax issues) may force an inadequately prepared taxpayer to concede some issues at the expense of litigating others.

From Mark O. Dietrich, CPA, Dietrich @ Wilson, P.C. (not a Summit affiliate), Framingham, Mass.
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Author:Dietrich, Mark O.
Publication:The Tax Adviser
Date:Aug 1, 1992
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