IRS Issues Long Awaited Hospital Study

February 18, 2009

On February 12, 2009, the Internal Revenue Service (“IRS”) Tax Exempt and Government Entities Division issued its 191-page Exempt Organizations Hospital Compliance Project Final Report (the “Final Report”). The Final Report is a result of responses to questionnaires the IRS sent in May of 2006 to more than 500 nonprofit hospitals addressing their compliance with the “community benefit” standard. The Final Report also contains data on the executive compensation practices of at least 20 nonprofit hospitals.

The community benefit standard is a method used by the IRS to determine if a nonprofit hospital is exempt from federal income tax under Section 501(c)(3) of the Internal Revenue Code. This standard uses facts and circumstances to assess whether a hospital is tax-exempt or taxable.

Tax-exempt hospitals may only pay reasonable compensation to their directors, officers, trustees, highly compensated employees and certain other related persons. Currently, Internal Revenue Code Section 4958 allows all tax-exempt organizations, including nonprofit hospitals, to rely on a rebuttable presumption process to establish that compensation is reasonable. Thus, under Section 4958, a tax-exempt hospital may place the burden of proving excessive compensation on the IRS by having disinterested persons to review comparability data to establish reasonable compensation and to substantiate the process used to set the compensation. The Final Report summarizes the community benefit and executive compensation data across four (4) community types where the nonprofit hospitals are located which are:

  • High-population hospitals;
  • Other urban and suburban hospitals;
  • Critical access hospitals; and
  • Other rural hospitals.

The report also contains community benefit and executive compensation data based on five (5) categories of annual revenues for nonprofit hospitals:

  • Under $25 million;
  • $25 million to $100 million;
  • $100 million to $250 million;
  • $250 million to $500 million; and
  • Over $500 million.

The Final Report identifies considerable differences in community benefits activities based on nonprofit hospitals’ location and financial resources. The Final Report specifically noted that:

  • Nonprofit hospital community benefit expenditures increase as hospital revenue increases.
  • Nonprofit hospitals spend an average of between 6% and 9% of their total revenues on community benefits.
  • Uncompensated care is the largest reported community benefit expenditure for nonprofit hospitals, followed by medical education and training, medical research expenditures and community programs.
  • As a group, the revenues of the nonprofit hospitals surveyed exceeded their expenses by 5% even though 21% of the nonprofit hospitals surveyed reported total expenses greater than total revenues.
  • No correlation exists between a nonprofit hospital’s community benefit expenditures and the per capita income levels of the nonprofit hospital’s surrounding area.

The report also acknowledges that while compensation paid by nonprofit hospitals might appear high, 85% of the nonprofit hospitals surveyed are following the applicable IRS regulations in setting executive compensation, and almost all of the nonprofit hospitals surveyed stated that they used comparability date when determining compensation. The average and median total compensation amounts for the top management position at nonprofit hospitals are $490,000 and $377,000, respectively, with higher levels of compensation paid at urban and suburban nonprofit hospitals.

The report does not recommend or change the current community benefit standard or the reasonable compensation standard. It also does not establish definitive criteria for an entity to obtain and to keep tax-exempt status.

The report confirms, however, that there is continuing pressure on the IRS to institute changes to both the community benefits and the reasonable compensation standards but that such changes will not be easily made by the IRS.

The IRS expects discussions on community benefit to continue as the IRS will receive more data on community benefit expenditures through the new Schedule H of the Form 990. The IRS will also continue its examinations of executive compensation standards.