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Hospital Tax Exemption Basics

Hospital Tax Exemption – An Overview

The recent release of the IRS Final Report in its three year long Exempt Organization Hospital Study is only one example of the increased scrutiny by the federal government into the exampt status of hospitals.  The critics state that the distinction between the services provided by tax exempt hospitals and for-profit hospitals has blurred over time.  This has lead to increased scrutiny on Capitol Hill as well as inside the IRS.  More and more, hospitals are being put in the spotlight and being asked to justify their tax exemption.  As bailouts and other use of federal funds create more sensitivity with the public, hospitals can expect more questions to be asked about ther public benefits that justify tax exempt status, whether or not this inquiry is a fair one.

If a hospital qualifies as a “charitable organization,” it is generally exempt from paying federal income taxes.  In order for a hospital to receive and maintain this tax exempt status, it must meet very specific requirements that are set forth in federal tax law and in IRS regulations.  Generally, all of these specific requirements and tests focus on two principal factors that tax exempt organization must meet.  First, they must be organized and operated exclusively for at least one of the specific purposes laid out in the Internal Revenue Code.  Second, no portion of the hospital’s earnings may inure to the benefit of any private individual or owner.

There is no simple formula for when a specific hospital meets the IRS requirements.  The IRS looks at all of the facts and circumstances to make the determination of tax exempt status. Some of these factors include whether the hospital has a full-time emergency room where service is provided without reference to the ability to pay, whether the medical staff is open, whether the governing board include independent representatives that are drawn from the community, whether services are provided to patients with Medicare and Medicaid coverage, whether training, education and research are performed, and whether the organization has a formal charity care policy.

One significant factor under the “private inurement” test, is whether any excess benefit is confered on certain qualified persons.  In March of 1998, the IRS finalized rules regarding “excess benefit transactions,” and their effect on a hospital’s tax exempt status.  Excess benefits transactions occur when certain qualified individuals are provided with benefits that are in excess of fair market value or when the benefit is otherwise unreasonable under the circumstances.  Excess benefit transaction expose the organization to the imposition of an excise tax.  The IRS regulations had been pending since 1995 and contained very few changes in their final form.  The regulations set forth some factors that the IRS will look at when assessing whether to revoke a hospital’s tax exempt status as a result of excess benefit transactions.  The factors shed some light on when the IRS will consider the excess benefits to be significant in relationship to the overall activities of the hospital.

One important factor that was considered by the IRS was whether the organization has implimented safeguards that are reasonably calculated to prevent excess benefit transactions.  It is recomended that all hospitals impliment policies to safeguard against excess benefit transactions.  The organization should consider implimenting these policies as a matter of general corporate or fiscal management.  However, the IRS will also consider safeguards that are implimented in reaction to the specific excess benefit transaction that may be at issue.

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John H. Fisher

Health Care Counsel
Ruder Ware, L.L.S.C.
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