Do nonprofit hospitals provide community benefit? A critique of the standards for proving deservedness of federal tax exemptions.

• Author: Folkerts, Laura L.

1. INTRODUCTION II. BACKGROUND A. History of the Standards for Nonprofit Hospitals 1. The Charity Care Standard 2. The Community Benefit Standard 3. Criticisms of the Community Benefit Standard 4. Criticisms of Nonprofit Hospitals B. Recent Action by the Senate Finance Committee 1. The Committee Staff's Proposals 2. Reactions to the Prospect of New Legislation C. Recent Action by the Internal Revenue Service 1. Reporting Requirements for Tax-Exempt Hospitals 2. The IRS's "Hospital Compliance Project" 3. The IRS's Recent Amendments to Form 990 III. ANALYSIS A. Analyzing the Senate Finance Committee's Actions 1. Quantitative Measure of Community Benefit 2. Defining "Charity Care" 3. Accountability and Transparency 4. Sanctions B. Analyzing the IRS's Actions IV. RECOMMENDATION A. Congress Should Enact Legislation to Replace Revenue Ruling 69-545 1. Charity Care Policy 2. Joint Ventures 3. Community Needs Assessments 4. Calculating Charges 5. Board of Directors 6. Quantitative Standards 7. Reporting Requirements 8. Sanctions B. Congress Should Define All Critical Terminology C. The IRS Should Refine and Enforce Redesigned Form 990 V. CONCLUSION I. INTRODUCTION

   According to Senator Charles Grassley, (1) we are at a "critical crossroads for nonprofit hospitals." (2) Many qualified nonprofit hospitals have received great financial benefits from tax exemption. (3) For example, in 2002, qualified nonprofit hospitals reportedly saved $2.5 billion in income taxes and $1.8 billion through the use of tax-exempt bonds. (4) Whether they deserve these exemptions is questionable. A 1990 report by the Government Accountability Office (GAO) showed that "57 percent of the nonprofit hospitals provided less charitable care than the value of the tax exemption they received." (5) This conflicts with the rationale for tax exemptions: that the benefits nonprofit hospitals provide to society outweigh the benefits that the government would receive from taxing the organizations. (6) Despite congressional proposals in 1991 for stricter standards, (7) the community benefit standard remains in effect. (8) The debate over deservedness has recently reignited, and nonprofit hospitals have been under great scrutiny for the tax exemptions they receive. (9) A study by the Congressional Budget Office (CBO) found that nonprofit hospitals still provide only a mean of 4.7% uncompensated care as a share of total hospital operating expenses. (10) A small number of hospitals, where the majority of charity care is concentrated, significantly influence this average. (11) This suggests that a substantial number of nonprofit hospitals are not earning-but are still receiving-the same tax exemptions. Since nonprofit hospitals are important to the community, (12) and because it is unfair to allow undeserved tax exemptions, this issue demands serious attention from Congress, the Internal Revenue Service (IRS), and hospital directors.

   Part II describes the history of tax exemption for [section] 501(c)(3) hospitals, from the historical "charity care" tax exemption standard to the current "community benefit" standard. Part II also discusses the criticisms of the current standard and the action the government has taken to improve it. Namely, Part II addresses the discussion draft released by staff members of the Senate Finance Committee (the Committee staff) in July 2007 with proposals for improving the community benefit standard. Part II also discusses the IRS's redesign of Form 990, the tax form that [section] 501(c)(3) hospitals must file with the IRS each year. (13)

   Part III examines the Committee staff's proposals and subsequent reactions by interested persons, including hospitals and scholars. It also examines the changes and reactions to the redesigned Form 990. Part IV suggests that Congress should enact legislation to replace the community benefit standard. This legislation should largely reflect the Committee staffs proposals, with changes and additions discussed in Part IV. Part IV also recommends that Congress refine and enforce the redesigned Form 990.

2. BACKGROUND

   1. History of the Standards for Nonprofit Hospitals

      Since 1894, organizations that operate exclusively for one of the purposes described in LR.C. [section] 501(c)(3) have been exempt from federal income taxes. (14) In 1976, the U.S. Supreme Court explained that "[n]onprofit hospitals have never received these benefits [from tax-exemption] as a favored general category, but an individual nonprofit hospital has been able to claim them if it could qualify as a corporation 'organized and operated exclusively for ... charitable ... purposes' within the meaning of [section] 501(c)(3) of the Code." (15) A hospital's tax-exempt status is determined on a case-by-case basis, so each hospital must individually prove that it qualifies as a charitable organization. (16) Since the IRS has the authority to enforce the Internal Revenue Code, (17) the IRS determines whether a nonprofit hospital qualifies as a charitable organization under [section] 501(c)(3). (18) In interpreting [section] 501(c)(3), the IRS places specific limitations on which organizations are eligible for this benefit. In addition to the standards described throughout this Part, the organization must be formed exclusively for a charitable purpose, its assets must be dedicated to this purpose, and a substantial amount of its activities must further this purpose. (19)

      1. The Charity Care Standard

         Throughout its history, the IRS has used different standards to determine whether a hospital is "charitable" under [section] 501(c)(3). In 1956, the IRS issued Revenue Ruling 56-185, which implemented "charity care" and "financial ability" standards for determining whether hospitals deserved tax exemptions. (20) The charity care standard of Revenue Ruling 56-185 generally required the following:

         (1) the hospital must be organized as a nonprofit charitable organization, the purpose of which is to operate a hospital [that] cares for the sick; (2) the hospital must be operated so that services are provided, to the extent of its financial ability, to those who are not able to pay and not exclusively to those who are able and expected to pay; (3) the use of the hospital's facilities must not be limited to a particular group of surgeons and physicians ... to the exclusion of all other qualified doctors; and (4) the hospital's net earnings must not inure directly or indirectly to the benefit of any private shareholder or individua1. (21)

         The charity care standard is a reflection of the long-lasting belief that helping the poor should be the determining factor in deciding whether an entity is a charity. (22) The standard is also consistent with the fact that early nonprofit hospitals served indigent persons and thus operated as a type of charity. (23) However, by 1969 the IRS found that changing times necessitated a reformed standard. (24)

      2. The Community Benefit Standard

         In 1969, the IRS issued Revenue Ruling 69-545, (25) which replaced the charity care standard with a "community benefit" standard. (26) Two main factors influencing the shift were the changing patient base of nonprofit hospitals and the effect of Medicare and Medicaid. (27) Nonprofit hospitals started serving more than just indigent persons, (28) and the paying patients generated most of their revenue. (29) Expectations of nonprofit hospitals also changed when the government started paying for health care services for the poor and elderly through Medicare and Medicaid. (30) As a result, the IRS broadened the definition of "charitable" to "include[] over a dozen ways to achieve that status," including "the 'promotion of health."' (31)

         The IRS intended the community benefit standard to be a more flexible standard. (32) Accordingly, the IRS eliminated the requirement that nonprofit hospitals must provide health care at a free or reduced cost. (33) The IRS also provided factors that courts should consider when determining whether a hospital is charitable for tax purposes. (34) These factors include:

         (1) whether a board of trustees control[s] the hospital and, if so, whether civic leaders compose the board; (2) whether the hospital has an open medical staff and extends privileges to all qualified physicians in the area; (3) whether the hospital operates an active and accessible emergency room, (35) regardless of patients' ability to pay; (4) whether the hospital provides medical care to all persons able to pay; and (5) whether surplus funds, when used, improve the quality of patient care. (36)

         Courts recognize that these are merely factors for consideration; absence of one or more factors does not prevent a hospital from obtaining [section] 501(c)(3) tax-exempt status. (37) Despite the IRS's push for more charity care, the community benefit standard remains the standard for determining tax-exempt status. (38)

      3. Criticisms of the Community Benefit Standard

         Scholars and policymakers alike believe the community benefit standard is flawed. According to the CBO, "[a]lthough nonprofit hospitals must provide community benefits in order to receive tax exemptions, there is little consensus on what constitutes a community benefit or how to measure such benefits." (39) In addition to believing that the community benefit standard is unworkable, people also criticize the standard for not requiring free health care for the poor (40) and for lacking accountability. (41) Scholars have suggested that "[u]nder the current community benefit standard, it is entirely possible for a nonprofit hospital to provide less charity care than a for-profit counterpart and still be tax exempt." (42)

         The judicial system has also weighed in on the community benefit standard. (43) Federal courts generally show support for the community benefit standard, (44) though their application of the standard has been somewhat inconsistent. In St. David's Health Care System v. United States, (45) the Fifth Circuit held that...