Vol. 4, No. 1, Pg. 25. Charitable Hospitals Tax Exempt Status at Risk.

• Author: By David W. Ball

South Carolina Lawyer

1992.

Vol. 4, No. 1, Pg. 25.

Charitable Hospitals Tax Exempt Status at Risk

25Charitable Hospitals Tax Exempt Status at RiskBy David W. BallIRS General Counsel Memorandums (GCMs) usually deal with technical tax matters and are not reported in newspapers. However, in December 1991 the IRS issued GCM 39862, which was reported in the Wall Street Journal and USA Today, for good reason. GCM 39862 reverses the IRS' longstanding treatment of hospital-physician relations and threatens the tax exempt status of many hospitals.

Background

In 1983 Medicare changed its reimbursement method for hospitals. Under the old method, hospitals were reimbursed using a retrospective cost-based system. Under the new prospective payment system, hospital reimbursements are based on payment categories called Diagnostic Related Groups (DRGs), with payment fixed prospectively. As a consequence of the DRGs, hospitals have strong financial incentives to admit more patients and release them more quickly. Because hospitals receive most of their patients as referrals from private practice physicians, hospitals have sought to establish stronger physician relationships to ensure a greater physician referral stream. Hospitals have entered into joint ventures and other arrangements with physicians to "bond" the physicians to the hospitals.

Before GCM 39862, these arrangements were generally viewed as acceptable and in fact had been blessed by numerous favorable private letter rulings (PLRs) issued by the IRS. GCM 39862 reverses the IRS position set forth in three earlier PLRs and casts significant doubt on the continued tax exempt status of hospitals that engage in such arrangements.

Tax Exempt Status Requirements

For a charitable organization to qualify for tax exempt status under Internal Revenue Code (IRC) Section 501(c)(3), among other requirements, no part of the net earnings of the charitable organization may inure to the benefit of a private shareholder or individual. To satisfy this tons must be met:

* there must not be any private inurement and

* any private benefit must be incidental to the public benefit.

Private inurement occurs if the net earnings or other assets of an exempt organization improperly benefit "insiders"--generally considered to be officers, directors or persons who created the organization. The IRS, even before GCM 39862, has taken the position that physicians with hospital staff privileges are insiders. There is no de minimus exception for the private inurement requirement. Payment of reasonable compensation to physician employees and independent contractors does not constitute private inurement, however.

A private benefit that results from a charitable organization's activities will not threaten its tax exempt status so long as the private benefit is only incidental to the public benefit derived from the activity. Here a de minimus exception is tolerated.

The Old View

Each of the three PLRs revoked by GCM 39862 involved the sale of the revenue stream from a division of the hospital to the hospital-physician joint venture.

In the first PLR, the net revenue streams of the outpatient surgical program and gastroenterology laboratory were sold. The IRS was told that this would offer a financial incentive to the physicians increase usage of the facilities.

In the second PLR, the joint venture acquired the gross revenue stream minus certain debts and expenses for the outpatient surgery department. The hospital maintained that operating its outpatient surgery department was costly and that it had recently been at increased financial risk from char including increased competition, in the health care marketplace. The hospital further claimed that, if it was unable to maintain physician support of its

26 outpatient surgery department, it might have to raise patient charges to cover its costs, and its ability to provide a wide range of outpatient surgical services and timely access to its outpatient surgery facilities might be affected.

In the third PLR, a joint...