Tax-exempt hospitals under IRS's watchful eye

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Remember Provena Health? It had portions of its property tax exemption removed in Illinois due to the comparatively low level of charity care it provided. It ultimately lost the battle to keep the exemption in the Illinois Supreme Court last year. It was a sobering blow to an organization with a Catholic orientation, particularly in a nation where such exemptions for religious organizations are nearly sacrosanct.

Provena's cautionary tale was further amplified earlier this year by the Internal Revenue Service (IRS), which issued a report saying it has had challenges administering the community health benefit--the expenditures for uncompensated care, education and other efforts non-profit hospitals use to justify their tax-exempt status.

It also reported difficulty administering the rebuttable presumption rule, which hospitals essentially use as an insurance policy for overpaying its executives. If the board can demonstrate that compensation tied the pay levels of executives at similar-sized hospitals and healthcare systems, concerns of enrichment become moot.

But with the IRS now taking a much closer look at these two critical factors, there are no doubt hospital chief financial officers wondering where and how the other shoe might drop. I decided to speak to a few legal and governance experts to see what path the agency's scrutiny might take.

There's some good news: The consensus is that the IRS won't be systematically yanking tax exemptions, or even doing it piecemeal. If any system is likely to face penalties, they would in the form of phased monetary penalties.

"Revocation of exemption is a last resort. The IRS would attempt other means first," said Milton Cerny, counsel at the Washington law firm McGuire Woods.

In particular, Cerny noted there is a $50,000 excise tax against a not-for-profit venture that failed to prove it was providing an appropriate community benefit. Although such a penalty could prove devastating to a small, rural hospital, the likely target of such a tax would likely be large teaching hospitals and multi-hospital systems. Pocket change, in essence.

That said, there are still red flags out there that could trigger an audit. They include characterizing normally elective procedures under the guise of charity care, according to Bob Atlas, chief operating officer of the Washington-based consulting firm Avalere Health. Those would include bariatric surgery or joint replacement.

"That's not to say there isn't ample justification for many procedures in (this) category," he said, but it could still catch the IRS's attention nonetheless.

Another ongoing red flag is excess compensation. According to the IRS report issued last March, the average compensation paid to a not-for-profit hospital CEO is $490,000, while the median is $377,000, with higher salaries skewing toward larger facilities in urban or suburban areas.

While the IRS believes most hospital management is hewing closely to the rebuttable presumption rule, Pam Knecht, president of Accord Limited, a healthcare governance consulting firm in Chicago, believes that the way such comparisons are being approached may be unwittingly raising the pay levels.

"I should start by saying I have no evidence of this actually happening, but it seems there is a possibility that when executive compensation firms are hired by Boards and/or CEOs to provide multiple examples of comparable compensation, the firms may report out the higher end of the comparables," Knecht said. However, she could not say specifically why the compensation firms would be motivated to do that.

What are the best ways to avoid potential entanglements on these issues? Knecht said hospital boards should consider establishing a community benefits committee to perform research and set standards for the hospitals and systems they govern for providing charity care. And, of course, exercising prudence when it comes to setting pay and pay scales for top management.

"We can assume that hospitals won't get pretty creative moving forward," Atlas said. - Ron