By virtue of their charitable status, almost every hospital in Maryland enjoys exemptions from federal, state and local taxes. However, (1) several local governments outside of Maryland are trying to revoke the real estate tax exemptions of certain charitable hospitals, (2) charitable hospitals are being sued in 25 states for failing to meet their charitable mandates, and (3) Congress is actively reconsidering the income tax exemption that it grants to charitable hospitals.
These developments are also likely to cause the Internal Revenue Service (IRS) and some of the fifty attorneys general to examine charitable hospitals more closely in the future. As a consequence, now more than ever, tax-exempt hospitals should focus on the reasons for their exemptions, evaluate the tactics of their critics, and initiate specific defensive measures.
A. Basis of Tax-Exemption
By qualifying for exemption from federal income tax, hospitals usually also qualify for exemption from many state and local taxes. Moreover, most hospitals qualify for exemption from federal income tax because they primarily operate for "charitable purposes." (Hospitals can also qualify for exemption by being an educational organization; however, the special tax issues affecting teaching hospitals are not covered in this article.)
Prior to 1969, the IRS viewed operating a hospital for "charitable purposes" as limited to providing free or subsidized health care services to the poor. In 1969, however, the IRS changed its position, and announced that a hospital would be deemed "charitable" if it met the following characteristics:
- The hospital must be organized as a non-profit charitable organization under state law and its governing body must be drawn from people from the community who are not otherwise financially interested in the hospital;
- Medical staff privileges in the hospital must be available to all qualified physicians, consistent with the size and nature of the hospital's facilities;
- The profits of the hospital may not be payable to private interests, and must usually be applied to expansion and improvement of the hospital's facilities; and
- The hospital must meet at least one of three additional criteria, namely:
- The hospital must be operated for the benefit of people who are not able to pay for medical services to the extent of the hospital's financial ability to render such services for free or at a reduced price; or
- The hospital must operate a full-time emergency room open to all regardless of ability to pay; or
- If operating an emergency room at the hospital's physical location would be duplicative, the hospital must benefit the community in some other way, such as providing specialized care in treating conditions that are unlikely to require emergency treatment.
Consequently, a hospital today may qualify as "charitable" even if it generally limits provision of medical services to patients who are able to pay for their care through private or public insurance or through their own resources. Charity care is not a requirement as long as the hospital satisfies the emergency room requirement, or some other hospital in the same general location satisfies the emergency room requirement and the hospital seeking exemption can show some kind of a public benefit from its existence.B. Health Care, Post-1969
Of course, the health care industry has changed dramatically since 1969.
In 1969, the Medicare and Medicaid Programs were in their infancy, but those Programs have now grown to be the most important funding mechanism for the health care of our elderly and poor. Also, hospitals, including for-profit hospitals, that participate in Medicare and have an emergency room are now required to treat any patient in an emergency condition (including patients who are not eligible for benefits under the Medicare and Medicaid Programs) regardless of the patient's ability to pay.
Ironically, industry experts have also come to realize that a hospital's emergency room is the door to the hospital's profits. Even if a hospital loses money on its emergency room, that hospital will often make up for that loss when one in five emergency room visits turns into a profitable hospital stay.
Consequently, Congress held hearings on the tax-exempt status of hospitals in May of 2005, and the IRS is presently examining whether to restrict tax-exempt status for hospitals to hospitals that provide care to the indigent to a greater extent than a for-profit hospital's duty to provide care under the Medicare Program. Such a requirement would be further complicated in Maryland, because Maryland's hospital rate setting system allows Maryland hospitals to "overcharge" Medicare, Medicaid and the commercial insurers to cover the hospitals' cost of providing inpatient services to the uninsured.C. Attempts to Revoke Tax Exemptions
Several local governments outside of Maryland have attempted to revoke the real estate tax exemptions of hospitals. The most notorious recent case involves the Provena Covenant Medical Center located in Champaign County, Illinois.
In 2004, it was determined that Provena is not entitled to its exemption from real estate tax, because:
- The hospital contracts with for-profit physician groups to be the exclusive providers of certain medical services performed at the hospital and allows those groups to bill for their services separately;
- The hospital gives insufficient amounts of care for free or reduced prices to members of the community;
- The hospital engages in price discrimination by charging higher prices to uninsured patients than it charges to patients who have insurance;
- The hospital files suits to collect unpaid hospital bills; and
- The hospital transfers funds from the tax-exempt entity to related for-profit entities.
Provena is appealing the decision. The health care industry and other local governments are closely monitoring this case, because most hospitals have significant exposure to local real estate taxes if their exemptions are revoked, and because many hospitals are also "guilty" of all five of the "sins" identified above.D. Private Class Actions
There have also been at least 46 class action lawsuits filed in 25 states (but not in Maryland) since 2004 tax-exempt hospitals, including a suit in Virginia against INOVA, and four suits in Pennsylvania.
The complaints in these cases usually allege the following underlying facts:
- The hospitals enjoy exemptions from federal and state income tax and state and local property taxes.
- The hospitals engage in price discrimination by charging uninsured patients significantly more for medical services than patients who are either covered by private insurance, Medicare or Medicaid.
- The hospitals are violating the Private Benefit Rule which prohibits private parties from having a financial interest in a tax-exempt entity. Specifically, the complaints usually allege that the hospitals are engaging in business deals with physicians, board members and other insiders, whereby the insiders are able to operate for-profit businesses using the hospitals' facilities.
- The hospitals provide insufficient free or reduced price health care to the poor in their respective communities in proportion to the tax exemption benefits that they enjoy.
- The hospitals publish false financial reports. One common alleged example is the classification of uncollectible accounts receivable as both bad debt and charity care.
As these cases wind their way through the courts, they have mostly been dismissed for failure to state a claim upon which relief may be granted, or won by the hospitals in summary judgment proceedings. However, a case in Oregon has been certified as a class action, and several hospitals in Mississippi have entered into settlement agreements.E. Recommendations
The recent conflicts with local taxing authorities, the activity of various plaintiffs' attorneys and the recent Congressional hearings are all part of a very real battle over the charitable nature of modern tax-exempt hospitals.
The hospitals are likely to win most of the class actions, but even one unfavorable result will be precedent for further cases. A similar dynamic is at work regarding local real estate tax disputes.
In light of the foregoing, tax-exempt hospitals should take the following steps now to reduce the momentum for unfavorable changes in the laws governing tax-exempt hospitals:Executive Compensation.
Compensation for highly paid management positions should be reviewed by the hospital's board of directors annually.Agreements with Private Health Care Providers.
Similarly, all agreements with private for-profit entities that provide health care services on behalf of the hospital should be scrutinized by the hospital's board of directors.Discriminatory Pricing.
Especially outside of Maryland, hospitals need to be sensitive that insurers often negotiate the price of health care below the amount that is charged to uninsured patients. This differential is often in excess of 50%. This behavior is limited within Maryland because of the State's hospital rate setting laws, but the problem still exists. Maryland's Health Services Cost Review Commission (HSCRC) does not set the rates for all services offered by Maryland hospitals. Therefore, boards of directors of Maryland hospitals should be aware of how this unregulated pricing is established, and determine the extent to which such pricing is appropriate.Community Benefit Report.
One of the requirements for tax exemption is that the community benefits from a hospital's existence, in ways other than the hospital providing market driven health care services. This requirement can be satisfied by providing health care for free or at a reduced price to the poor, by operating an emergency room that is open to all people irrespective of their ability to pay, or by some other benefit to the community, such as the provision of specialized health care that is not otherwise generally available. Tax-exempt hospitals need to be able to point to how they are helping their communities by preparing annual reports that catalogue their good works. In fact, Maryland now requires that each Maryland hospital file such a report with the HSCRC, and Maryland hospitals should take this opportunity seriously.Unmet Health Care Needs.
Hospitals should identify unmet health care needs in their communities, and then take steps to fill those gaps.Subsidized Care for the Poor.
Many people who would be considered as poor in the common sense of the word are too "rich" to be eligible for the Medicaid Program. Tax-exempt hospitals should consider whether they can provide free or subsidized care to these people. Moreover, adopting policies is not sufficient. Adopted policies also need to be implemented and monitored.Restricted Endowments.
Almost every hospital is a recipient of charitable bequests and grants. These gifts often are restricted in some way that is designed to subsidize a charitable activity. Sometimes, these restrictions are ignored and forgotten after several years. Tax-exempt hospitals should make a good faith effort to comply with these restrictions.Greater Transparency in Governance.
Tax-exempt hospitals should adopt and implement best practices guidelines such as those promulgated by the Better Business Bureau Wise Giving Alliance or by the Sarbanes-Oxley Act.
The bottom line is that taking a step back to the past, and respecting the hospital industry's pre-1969 charitable origins, may be the best way for hospitals to continue to assure that their tax exemptions will be preserved in the future.