TREASURY
INSPECTOR GENERAL FOR TAX ADMINISTRATION
March 29, 2007
Reference Number: 2007-10-061
This
report has cleared the Treasury Inspector General for Tax Administration
disclosure review process and information determined to be restricted from
public release has been redacted from this document.
Phone Number |
202-927-7037
Email Address | Bonnie.Heald@tigta.treas.gov
Web Site |
http://www.tigta.gov
March 29, 2007
MEMORANDUM FOR COMMISSIONER, TAX EXEMPT AND GOVERNMENT ENTITIES DIVISION
FROM: Michael R. Phillips /s/ Michael R. Phillips
Deputy Inspector General for Audit
SUBJECT: Final Audit Report – Tax-Exempt Hospital Industry Compliance With Community Benefit and Compensation Practices Is Being Studied, but Further Analyses Are Needed to Address Any Noncompliance (Audit # 200610040)
This report presents the results of our review to determine the purpose and scope of the Exempt Organizations (EO) function’s tax-exempt hospital compliance project and how management intends to use the results to address potential noncompliance in the industry. A Senior Staff Advisor of the Senate Finance Committee voiced concerns to the Treasury Inspector General for Tax Administration that laws governing tax-exempt hospitals have not changed since their inception in 1956 and revisions in 1969, and there seems to be little difference between tax-exempt and for-profit hospitals. The Senior Staff Advisor requested that the Treasury Inspector General for Tax Administration review the Tax Exempt and Government Entities Division’s planned actions related to compliance in the tax-exempt hospital area.
Impact on the Taxpayer
According to the Congressional Budget Office, nonprofit hospitals received more than $6 billion in Federal tax exemptions in 2002. EO function management is conducting the hospital compliance project to assess how tax-exempt hospitals believe they provide a community benefit in exchange for tax-favored status. Management stated that project information may assist them in differentiating tax-exempt hospitals from for-profit hospitals and could result in regulatory changes or a Revenue Ruling.
Synopsis
As part of this compliance project, the EO
function sent a 9-page questionnaire to 544 tax-exempt hospitals
soliciting information on compensation practices and the community benefit
standard. At the time of our fieldwork, the
function was still analyzing the questionnaire responses and identifying
potential examinations of organizations based on the manner in which executive
compensation was determined. If information gathered in the compliance project
shows hospitals are performing only minimum actions to meet the community
benefit standard, the function will consider initiating examinations in this
area. Management stated that project information also may assist them in
differentiating tax-exempt hospitals from for-profit hospitals and in determining
whether legislative action would improve the Internal Revenue Service’s (IRS)
ability to administer tax laws in the tax-exempt hospital industry. Additionally,
the compliance project will gather information about the practices and
procedures tax-exempt organizations use to assign compensation to executives
and other outsiders and enhance compliance in this area, if necessary.
When the analyses are completed, EO function management will prepare two reports summarizing the results of the analyses of the questionnaires and related examinations. An interim report, due in July 2007, will present the results of the tax-exempt hospitals’ responses to the community benefit questions and include any recommendations on the next steps planned by the IRS to address the community benefit standard. At the end of our fieldwork, EO function management had not yet determined whether the interim report will be made publicly available. After the examinations related to executive compensation are completed, in September 2008 management plans to publicly issue a final report summarizing the results of the tax-exempt hospital compliance project. This report will provide an update on the community benefit standard since the issuance of the interim report; will include a summary of the examination results related to excess compensation; and could include recommendations to improve future compliance by tax-exempt hospitals, recommendations related to education and outreach efforts needed in these areas, and additional training for function personnel in compensation analysis for tax-exempt hospitals.
While the EO function has specific plans for addressing potential noncompliance for the executive compensation issue, it is still in the process of evaluating the responses and has not determined what is needed for the community benefit issue. Because of the complexity that currently exists in the industry and the potential for new regulations, we believe it is premature to plan for a final project report covering both executive compensation and community benefit issues. If extensive action is needed to address noncompliance in the community benefit area, including developing new Revenue Rulings or recommending regulatory changes, management may need to develop separate plans to accomplish this.
Recommendation
We recommended the Director, EO, Tax Exempt and Government Entities Division, ensure the interim report includes all planned actions related to community benefit issues and develop plans to prepare a separate final report on this issue if all necessary actions will not be completed for inclusion in the final compliance report scheduled for issuance in September 2008.
Response
IRS management generally agreed with our recommendation. The interim report will reflect the progress of the community benefit component of the hospital compliance project, contain a description of the community benefit activities undertaken by hospitals that responded to the questionnaire, and outline the IRS’ immediate next steps based on an assessment of the data. Management stated it was too early in the process to determine the need for a supplemental report on community benefit, or the precise next steps in the area, but agreed to issue a supplemental report if necessary. Management’s complete response to the draft report is included as Appendix IV.
Copies of this report are also being sent to
the IRS managers affected by the report recommendation. Please contact me at (202) 622-6510 if you
have questions or Nancy A. Nakamura, Assistant Inspector General for Audit (Headquarters
Operations and Exempt Organizations Programs), at (202) 622-8500.
Appendices
Appendix
I – Detailed Objective, Scope, and Methodology
Appendix
II – Major Contributors to This Report
Appendix
III – Report Distribution List
Appendix
IV – Management’s Response to the Draft Report
Abbreviations
|
EO |
Exempt Organizations |
|
I.R.C. |
Internal Revenue Code |
|
IRS |
Internal Revenue Service |
Nonprofit hospitals received more than $6 billion in Federal tax exemptions in 2002, according to the Congressional Budget Office.
Charities, educational institutions, and religious organizations are among those entities exempt from Federal income tax under Internal Revenue Code (I.R.C.) Section (§) 501(c)(3).[1] Although tax-exempt hospitals are not specifically listed in this Code section, they have long been recognized as charitable activities when certain conditions are met. Specifically, a hospital must be organized and operated exclusively for charitable purposes, and it may not be operated, directly or indirectly, for the benefit of private interests. Health-related organizations make up the largest percentage of I.R.C. § 501(c)(3) nonprofit organizations and account for almost 60 percent of total revenues. Hospitals generate almost three-quarters of the total revenue of health-related organizations.
The Exempt Organizations (EO) function of the Tax Exempt and Government Entities Division is responsible for ensuring organizations exempt from Federal income tax comply with applicable I.R.C. sections and regulations. The more recent of the 2 most significant Revenue Rulings related to tax-exempt hospitals was issued by the Internal Revenue Service (IRS) almost 40 years ago:
Revenue
Ruling 69-545 states that a hospital otherwise qualified for tax-exempt status
will meet the community benefit standard when it has a board of directors
composed of prominent citizens drawn from the community; has a medical staff consistent
with the size and nature of its facilities that is open to all qualified
physicians in the area; operates a full-time emergency room open to all persons
without regard to their ability to pay;[4] and provides hospital care for everyone in the
community able to pay the cost either themselves, through private health
insurance, or with the aid of public programs such as Medicare.
The Government Accountability Office has stated there
is often little to no difference between for-profit and tax-exempt hospitals
when it comes to charity care and community benefits provided. The IRS Commissioner has commented that some
tax-exempt health care providers may not differ markedly from for-profit
providers in their operations, their attention to the benefit of the community,
or their levels of charity care. Both the Senate Finance Committee and the
The IRS faces numerous challenges in administering oversight of the tax-exempt hospital industry. From Fiscal Year 1995 through the first half of Fiscal Year 2005, the IRS examined more than 375 health care organizations (out of a population of approximately 7,000), including both hospitals and related organizations or parts of hospital systems. However, EO function management stated that historical information related to closed examinations of tax-exempt hospitals did not contain details sufficient to assess whether specific compliance issues related to community benefit existed in the industry. In addition, the EO function’s inventory system contains one specific code that includes medical care, educational, and research organizations. This prohibits management from performing automated analysis of past compliance work specific to tax-exempt hospitals.
Also, there have been a number of changes in
the health care industry affecting the
application of the community benefit standard since the issuance of Revenue
Ruling 69‑545. Testifying before
Congress in May 2005, the IRS Commissioner stated the IRS’ ability to regulate
the compliance of tax-exempt hospitals is difficult when industry practice, or
the industry itself, has changed but the rules have generally remained constant
since 1969. The increased merger
activity in the health care sector in the 1980s and 1990s resulted in more
complex business structures, evolving this industry into something
substantially different from what it was when guidance was last issued. As a result of these challenges, outside
stakeholders have raised the issue that it may be the time for a more thorough
review of the tax-exempt hospital area to determine whether (1) the community
benefit standard is still applicable and (2) there are bright-line tests[6] that might be
available to aid tax-exempt hospitals in complying with the law and the IRS in
administering it.
This review was performed at the EO function Examinations
Great Lakes Area Office[7]
in Chicago, Illinois. We also
contacted Tax Exempt and Government Entities Division personnel in
Exempt Organizations Function Management Has Initiated Actions to Begin Assessing the Community Benefit and Compensation Practices of Tax-Exempt Hospitals
Changes to the health
care industry have resulted in the appearance that there are very few
differences in the manner in which nonprofit and for-profit hospitals operate. This is compounded by the fact that nonprofit
hospitals annually receive billions of dollars in tax exemptions from Federal
and State sources. Figure 1 outlines the
estimated value of tax exemptions provided to nonprofit[8] hospitals in Calendar Year 2002.
|
Figure
1: Estimated Value of Tax Exemptions
Provided to Nonprofit Hospitals, Calendar Year 2002 |
|
|
|
Value (billions of dollars) |
|
Corporate Income Tax (Federal) |
$ 2.5 |
|
Tax-Exempt Bond Financing (Federal) |
1.8 |
|
Charitable Contributions (Federal) |
1.8 |
|
Corporate Income Tax (State) |
0.5 |
|
Sales Tax (State and Local) |
2.8 |
|
Property Tax (Local) |
3.1 |
|
TOTAL |
$ 12.6[9] |
Source: Congressional
EO function
management stated its historical information related to tax-exempt hospitals did
not contain details sufficient to assess whether specific compliance issues
existed in the industry. As a result,
they began a compliance project[10] in Fiscal Year 2006 to learn more about current practices of these hospitals. Management indicated the compliance project
will identify the following information:
·
Whether a
legislative action would improve the IRS’ ability to administer tax laws in the
tax-exempt hospital industry.
EO function management believes information
gathered during this project may assist the IRS in restoring public trust in tax-exempt hospitals by identifying areas in
which the function can provide more education to its customers about complying
with the regulations and in helping tax-exempt hospitals establish strong
internal governance structures so they can comply with the I.R.C. If information gathered in the compliance
project shows hospitals are performing only minimum actions to meet the
community benefit standard, the function will consider initiating examinations
in this area. Management stated that project information also
may assist them in differentiating tax-exempt hospitals from for-profit
hospitals and could result in regulatory changes or a Revenue Ruling, if
necessary, related to a revised standard for tax-exempt status. Additionally,
the compliance project will gather information about the practices and
procedures tax-exempt organizations use to assign compensation to executives
and other outsiders and enhance compliance in this area, if necessary.
Methodology of the project
The EO function assembled a multifunctional team
to plan and implement the compliance project.
The team prepared a detailed Action Plan and Project Proposal that
outlined the objectives of the project, required action items, dates, resources
necessary, and potential actions that may be taken to address issues
identified.
In May 2006, the project team sent a compliance
check[11] letter and 9-page questionnaire to 544 tax-exempt
hospitals soliciting information on compensation practices and how tax-exempt
hospitals meet the community benefit standard.
The questionnaire contained the following three parts:
Ø Whether nonemergency services are available to everyone with ability to pay.
Ø Whether the hospital treats Medicare and Medicaid patients in a nondiscriminatory manner.
Ø How the hospital deals with the uninsured.
Ø Whether and how determinations of financial responsibility are made.
Ø The nature and extent of the hospital’s charity care policies and, if such a policy exists, how the hospital distinguishes charity care from bad debt.
Ø The nature and extent of medical research programs.
Ø The hospital’s participation in partnerships, limited liability companies, joint ventures, and Subchapter S corporations.[12]
Ø The hospital’s financial relationship with staff members and other closely connected individuals and entities.
Ø What additional guidance, education, and/or compliance actions are appropriate.
·
The third
part requested information to identify abuses by hospitals that pay excessive
compensation and benefits to their officers and other insiders. Information gathered in this portion of the
project will allow the EO function to:
Ø Address the compensation of specific individuals and instances of questionable compensation practices and procedures.
Ø Increase awareness of tax issues as hospitals set compensation in the future.
Ø Learn more about the practices and procedures that hospitals are following as they set compensation.
Ø Gauge the existence and effectiveness of the controls employed by hospitals over compensation issues.
Ø
Learn
more about how hospitals report compensation to the IRS and the public on their
annual Returns of Organization Exempt From Income Tax (Form 990).
The EO function originally requested a response from the 544 hospitals within 30 days, but a 30-day extension was granted.
Project status
The project team had received
responses for 533 (98 percent) of the 544 questionnaires by the end of our
fieldwork; 41 (8 percent) of the 533 organizations indicated they were not tax exempt
or had been dissolved. The EO function
initiated follow-up calls and letters to the 11 organizations that had not
responded.
At
the time of our fieldwork, EO function management was analyzing the responses to
the community benefit questions. They
stated that, when completed, this analysis may result in recommendations to
improve compliance for tax-exempt hospitals and differentiate their operations
from those of for-profit hospitals. Recommendations
could include regulatory changes or additional Revenue Rulings.
In
addition, the function is beginning an analysis of the tax-exempt hospitals’
responses to the executive compensation questions. As part of this analysis, personnel are
performing three separate steps to identify potential examinations of
organizations based on the manner in which executive compensation was
determined. At the end of our fieldwork,
management was analyzing these responses to identify those tax-exempt hospitals
that will be selected for examination. Management
stated the examinations related to executive compensation were scheduled to
begin in January 2007 and be completed by January 2008.
Third-party input
Given the depth and
complexity of the EO function’s tax-exempt hospital questionnaire, the American
Hospital Association[13] requested that Ernst
& Young, LLP perform an independent analysis of the questionnaire’s
community benefit answers submitted by their members. On June 19, 2006, the American Hospital Association
initiated a conference call that was open to any hospital that had received the
IRS questionnaire and included both Ernst & Young, LLP and IRS
personnel. The purpose of the call was
to help clarify issues from the questionnaires by providing the tax-exempt
hospitals the opportunity to speak with IRS personnel. As a result of the conference call, 132 of
the 533 tax-exempt hospitals that had responded to the EO function
questionnaire also submitted copies of their questionnaires to Ernst &
Young, LLP personnel. Based on their
analysis, Ernst & Young, LLP personnel prepared a report and documented a
number of “lessons learned” for the IRS, including:
·
Allow tax-exempt hospitals to tell their community benefit
story, in more than just yes/no or simple number responses. Community benefit may be difficult to measure,
and relying on only yes/no or quantitative responses may be misleading.
·
Request tax-exempt hospitals to provide copies of their
community benefit reports with their Forms 990.
·
Provide for clarity of definitions to ensure uniformity of
answers. For example, one question asked
if a tax-exempt hospital denied services to any
individuals. A tax-exempt hospital that
is “at capacity” would indicate to ambulances that it is unable to take new
cases. Based on this, some hospitals may
indicate they have denied services to individuals, while other hospitals may
consider this normal hospital operation and answer no because they would not
consider this denial of services.
In
May 2006, the Catholic Health Association[14]
developed a supplemental report that can be attached to Form 990. It believes attaching the supplemental report
will promote
consistency in the reporting of community benefit information and share the
community benefit contributions of tax-exempt hospitals with the IRS and the
public in a more organized, comprehensive, and consistent manner. The Catholic Health Association believes that,
through enhanced reporting of community benefit practices, a tax-exempt
hospital will be better equipped to demonstrate to Government agencies and its
community that its tax-exempt status is warranted. The Chairman of the Senate Finance Committee
issued a statement praising this report and encouraged tax-exempt hospitals to
use the report when they file Forms 990.
In Fiscal Year 2003,
the EO function Examination office began a comprehensive project to redesign
the Form 990 to provide better compliance information to the IRS, the States,
and the public. This project will
continue in Fiscal Year 2007, with a draft revision of the Form 990 expected by
summer 2007. EO function management indicated that additional revisions to the Form
990 could be made to better identify community benefit actions of tax-exempt
hospitals and may assist in future compliance efforts, if warranted, based on
their analysis of the questionnaire responses.
Project work remaining
Through review of compliance project documentation and interviews with EO function management, we determined two reports will be prepared summarizing the results of the function’s analyses of the questionnaires and related examinations. First, an interim report will present the results of the tax-exempt hospitals’ responses to the community benefit questions. According to management, the interim report will summarize the information obtained from the questionnaires and discuss how tax-exempt hospitals demonstrate their qualifications for exemption as organizations described in I.R.C. § 501(c)(3) under the community benefit standard articulated in Revenue Ruling 69-545. The interim report will also include any recommendations on the next steps planned by the EO function to address the community benefit standard. A draft of this report was tentatively scheduled to be provided on January 31, 2007, to the Tax Exempt and Government Entities Division Executive Steering Committee for review. The interim report is scheduled for issuance by July 31, 2007. At the end of our fieldwork, management had not yet determined whether the interim report will be made publicly available.
After the examinations related to executive compensation are completed, in September 2008 EO function management plans to issue a final report summarizing the results of the tax-exempt hospital compliance project. This report will provide an update on the community benefit standard since the issuance of the interim report; will include a summary of the examination results related to excess compensation; and could include recommendations to improve future compliance by tax-exempt hospitals, recommendations related to education and outreach efforts needed in these areas, and additional training for function personnel in compensation analysis for tax-exempt hospitals. Management also may determine that more follow-up actions, such as additional compliance initiatives/projects, are necessary for the tax-exempt hospitals industry.
Management tentatively plans to issue this report publicly, as has been done for past reports summarizing the results of compliance projects such as the Credit Counseling Compliance Project and the Political Activities Compliance Initiative. In both of those projects, the prepared reports summarized the projects’ results and contained recommendations and enhancements for future actions to address compliance issues. Those reports were issued publicly on the IRS Internet site.
According to the EO function Hospital Project Proposal, the
final report for the Hospital Project will include summarization of results,
recommendations to improve future compliance, educational efforts, training
needs, and follow-up actions. While the
EO function has specific plans for addressing potential noncompliance for the
executive compensation issue, it is still in the process of evaluating the
responses and has not determined what is needed for the community benefit
issue. Because of the complexity that
currently exists in the industry and the potential for new regulations, we
believe it is premature to plan for a final project report covering both
executive compensation and community benefit issues. If extensive action is needed to address
noncompliance in the community benefit area, including developing new Revenue
Rulings or recommending regulatory changes, management may need to develop
separate plans to accomplish this.
Recommendation
Recommendation 1: The Director, EO, Tax
Exempt and Government Entities Division, should ensure the interim report includes an assessment of how tax-exempt
hospitals are providing a community benefit, as well as any planned actions
management determines are necessary to address the community benefit standard
(e.g., revised Revenue Rulings, discussions with Department of the Treasury
officials on potential regulatory changes, necessary education and outreach
efforts, potential examinations) based on their evaluation of this issue. In addition, management should develop plans
to prepare a separate final report on community benefit if all necessary
actions will not be completed for inclusion in the final compliance report
scheduled for issuance in September 2008.
Management’s Response: IRS management generally agreed with this recommendation. The interim report will reflect the progress of the community benefit component of the hospital compliance project, contain a description of the community benefit activities undertaken by hospitals that responded to the questionnaire, and outline the IRS’ immediate next steps based on an assessment of the data. Management stated it was too early in the process to determine the need for a supplemental report on community benefit, or the precise next steps in the area, but agreed to issue a supplemental report if necessary.
Appendix I
Detailed Objective, Scope, and Methodology
The overall objective of this review was to determine the purpose and scope of the EO function’s tax-exempt hospital compliance project and how management intends to use the results to address potential noncompliance in the industry. Internal controls relate to management’s plans, methods, and procedures used to meet its mission, goals, and objectives; include the processes and procedures for planning, organizing, directing, and controlling program operations; and include the systems for measuring, reporting, and monitoring program performance. We determined the following internal controls were relevant to our audit objective: the EO function’s policies, procedures, and practices for planning and implementing its tax-exempt hospital compliance project. We reviewed these controls by interviewing function management and analyzing applicable project documentation. We did not identify any significant material weaknesses. To accomplish our objective, we:
I. Determined whether the EO function provided adequate oversight in planning and implementing its tax-exempt hospital compliance project.
A. Obtained and analyzed background documentation on the planning process of the project.
B. Interviewed applicable project team members and determined their roles and responsibilities in the project.
C. Determined how the function ensured the sampled organizations responded to the questionnaire and whether the responses were completely and accurately recorded.
II. Evaluated how the EO function intends to use the results of the hospital questionnaires to identify and address noncompliance and to determine whether any changes to the community benefit standard are needed.
A. Assessed the process to analyze project results and identify issues for further actions.
B. Determined whether function management had identified any potential noncompliance issues from the responses received to date.
C. Determined what steps, if any, the function will take to address the issues raised by the responses to the hospital questionnaire.
D. Determined whether management had developed or plans to develop any guidance related to tax-exempt hospitals based on results to date.
E. Determined how management plans to report the results of the project to stakeholders and customers.
Appendix II
Major Contributors to This Report
Nancy
A. Nakamura, Assistant Inspector General for Audit (Headquarters Operations and
Exempt Organizations Programs)
Gerald
T. Hawkins, Acting Director
Jeffrey
M. Jones, Audit Manager
Margaret
A. Anketell, Senior Auditor
Donald
J. Martineau, Auditor
Carol
A. Rowland, Auditor
Appendix III
Commissioner C
Office of the Commissioner – Attn: Chief of Staff C
Deputy Commissioner for Services and Enforcement SE
Deputy
Commissioner, Tax Exempt and Government Entities Division SE:T
Director, Exempt Organizations, Tax Exempt and Government Entities Division SE:T:EO
Chief Counsel CC
National Taxpayer Advocate TA
Director, Office of Legislative Affairs CL:LA