How Good a Samaritan? Federal Income Tax Exemption for Charitable Hospitals Reconsidered

• Publication year: 1991

UNIVERSITY OF PUGET SOUND LAW REVIEWVolume 14, No. 3SPRING 1991

How Good a Samaritan? Federal Income Tax Exemption for Charitable Hospitals Reconsidered

James B. Simpson and Sarah D. Strum(fn*)

I. Introduction

For many years charitable, nonprofit hospitals have received income, property, and other tax exemptions.(fn1) These tax subsidies were enacted at a time when hospitals were primarily operated to provide recuperative care without charge to the indigent and the destitute.(fn2)

In the latter half of the twentieth century charitable hospitals have changed dramatically.(fn3) Today's charitable hospitals make available a technologically sophisticated setting in which physicians and other health personnel perform complex diagnostic and therapeutic procedures. Charitable hospitals have become wealthy institutions, with power and presence in the community far beyond their almshouse forebears. The indigent are seldom encouraged, and are sometimes shunned, from seeking treatment in many of these institutions. Instead, charitable hospitals compete with profit-making hospitals for a share of the privately and publicly insured patient market. Despite these changes, charitable hospitals have enjoyed an essentially unquestioned exemption from income, property, and other taxes; access to tax-exempt financing; and other tax subsidies.

Do contemporary charitable hospitals provide a sufficient community benefit to justify the loss of government revenue caused by their tax exemption? Focusing particularly on federal income tax exemption and on the community benefit derived from the provision of services to persons unable to pay, this Article argues that not all hospitals do. Accordingly, the authors recommend that the Internal Revenue Service issue a Revenue Ruling revising the current standards for federal income tax exemption to encourage charitable hospitals to clearly and explicitly identify and respond to health care needs, including the needs of persons unable to pay, in their local communities. The proposed text of such a ruling is set forth in an appendix to this Article.

II. Changing Hospital Market

The provision of charity care is discouraged by the contemporary hospital market. This is largely the result of actions taken in the past ten years by payors of hospital care: state and federal governments and private insurance companies. Seeking to stem the inexorable inflation of medical care costs in recent decades, public and private payors have established hospital payment mechanisms that implicitly or explicitly encourage nonprofit hospitals to reduce internal subsidies for unpaid services and to compete on the basis of price. If the basis for hospital tax exemption continues to be the provision of uncompensated services as a quid pro quo for the tax subsidy, current hospital payment strategies and tax exemption may be operating at cross purposes.

A. Expansion of Proprietary Hospital Sector

The increased share of the hospital market held by proprietary institutions has prompted concern that the tax laws unfairly discriminate between nonprofit and proprietary hospitals. Nonprofit and proprietary hospitals increasingly look more alike than different, both when measured in terms of efficiency and provision of uncompensated services.(fn4) A tax subsidy for one otherwise indistinguishable sector of the hospital industry may dilute the economic incentives built into new payment systems by supporting inefficient nonprofit institutions or discouraging the expansion of their more efficient competitors.(fn5)

B. Access to Hospital Care

There is a growing recognition among health policymakers and legislators that medical indigency is a serious and widespread problem in the United States. Statistics and anecdotal evidence support this view. It is estimated that 30 to 38 percent of Americans, from 58.8 to 63.0 million people, are uninsured or underinsured.(fn6)

C. Changing Public Perception of the Hospital

In addition, the public has become uneasy with the increasingly commercial behavior of hospitals. A recent national public opinion survey reported that 67 percent of respondents believe nonprofit hospitals are essentially "commercial" entities, not social service organizations.(fn7) State and local property tax officials have made numerous well-publicized efforts to forfeit the property tax exemption of nonprofit hospitals.(fn8) The popular press has recounted numerous horror stories of denial of care to persons unable to pay.(fn9) Legislation has been proposed that would curtail access to tax-exempt bond financing for hospitals not providing a minimal volume of care to the poor and link the federal income tax exemption to the provision of specified levels of charity care.(fn10) Forty-five percent of the public believe that nonprofit hospitals should forfeit their tax exemption.(fn11)

D. Nonprofits Under Fire

The tax status of the entire nonprofit sector has been questioned in recent years. The impetus for this scrutiny has come from several fronts. There has been increasing competition between nonprofit and proprietary businesses. Travel agencies, private educational institutions, sports clubs, and a variety of health care providers have objected to the incursion of nonprofits into their entrepreneurial domains and to the subsidy they enjoy. The Small Business Administration has devoted considerable attention to the issue, and the House Ways and Means Committee on Tax Oversight has conducted hearings on the "unrelated business income" of exempt organizations.(fn12) In the wake of the taxpayer's revolt, local governments have sought to identify new sources of tax revenue. It has been suggested that exempt organizations, particularly those such as hospitals that provide essentially commercial services, are as heavy of a user of tax-supported public services such as police, fire safety, and public roads as their taxable counterparts. Tax exemption allows them to free-ride, increasing the tax burden of non-exempt organizations.(fn13)

E. New Techniques for Tax Expenditure Analysis

In addition to direct expenditures, the federal budget contains indirect expenditures accomplished through the tax system.(fn14) When the tax code grants preferential treatment to particular kinds of income through deductions, credits, or exclusions, the government spends money on the underlying object of that income as surely as if it had appropriated and spent the funds.

Congress and the public have not traditionally subjected the cost and relative value of this type of tax expenditure to the scrutiny given direct expenditures.(fn15) However, in recent years the federal government has paid increasing attention to the cost and utility of tax expenditures.(fn16) Tax exemption for nonprofit charitable organizations has been recognized as a tax expenditure.(fn17) Recently, the U.S. General Accounting Office evaluated the cost and utility of the federal income tax exemption for nonprofit hospitals by calculating the revenue loss associated with the federal and state charitable hospital income tax subsidies and comparing this amount with the estimated value of charity care provided by the hospitals.(fn18) Evidence from the GAO Report suggests that there are many charitable hospitals that cost society more than they provide in return.(fn19)

F. Hospital Exemption

At the present time charitable hospitals unquestionably qualify for federal income tax exemption.(fn20) The most recent IRS revenue ruling on this issue states that the provision of hospital services is an exempt charitable purpose as long as a hospital promotes the health of a class of persons broad enough to benefit the community and operates to serve public rather than private interests.(fn21) A hospital may meet these standards if it offers services to those who can pay, including Medicare and Medicaid patients; has a governing board of prominent citizens and an open medical staff policy; and applies surplus funds to improving operations, capital plant, medical education, and research.(fn22) It need not provide what is known as "charity care": services to indigent patients without expectation of payment.(fn23)

Of course, the majority of charitable hospitals provide at least some charity care. Some deliver substantial amounts.(fn24) The impetus to do so, however, likely comes more from an internally-generated sense of mission or an accident of proximity to a poor neighborhood than from concern with Internal Revenue Code compliance.

This state of affairs would certainly surprise those who administered the federal income tax laws for the first forty-plus years of their existence.(fn25) It would probably startle those who founded America's first hospitals, for the very notion of a charitable hospital that did not serve the poor would seem utterly foreign to them.(fn26) It seems particularly surprising in light of the multi-billion dollar tax subsidy granted to charitable hospitals by the federal government.(fn27)

G. Origins of Federal Income Tax Exemption for Charitable Hospitals

Exemption provisions for charitable organizations have always been present in federal income tax laws. The first broad corporate income tax, the Tariff Act of 1894, exempted "corporations, companies, or associations organized and conducted solely for charitable, religious, or educational purposes."(fn28)...