EXEMPT ORGANIZATION UPDATE


In light of the recent IRS and Congressional scrutiny on tax exempt organizations, some of the latest legal developments of which you should be aware are highlighted below.

 Executive Compensation Practices Under IRS Scrutiny
The IRS has launched the Tax Exempt Compensation Enforcement Project, a major effort to examine internal financial issues of charities and foundations. IRS Announcement 2004-206, issued August 10, 2004, stated that nearly 2,000 charities and foundations will be contacted and asked for information about their salary practices and procedures. The purpose of this project is to address the compensation of specific individuals or instances of questionable compensation practices, increase awareness of tax issues as organizations set future compensation and learn more about the practices organizations are following as they set compensation and report it to the IRS and the public on their annual Form 990 returns.

IRS Focuses Attention on Excess Benefit Transaction
On August 27, 2004, the IRS released five Technical Advice Memoranda that address whether the use of exempt organization assets constitute excess benefit transactions (EBT) for purposes of potential intermediate sanctions penalties. Although not substantively new, the TAM’s provide clarity to the IRS’ position. The IRS also recently announced that it will be reviewing EBT’s reported on Form 990 by tax-exempt organizations as well as any failure of an exempt organization to indicate on the Form 990 whether it has had any excess benefit transactions.

IRS Issues a Key Revenue Ruling on Joint Venture
On May 6, 2004, Revenue Ruling 2004-51 was issued, which indicates the IRS’ intent to minimally scrutinize ancillary joint ventures – those that do not involve a substantial part of an exempt organization’s assets.

IRS Reissues Guidance on Political Activities
In a letter sent to national political parties on June 10, 2004, the IRS reissued guidance regarding political activities by tax-exempt organizations. The letter reminds 501(c)(3) organizations of the prohibitions against directly or indirectly participating or intervening in any political campaign on behalf of, or in opposition to, any candidate for public office.

Congressional Committees to Investigate Non-Profits
Three separate Congressional committees are currently investigating tax-exempt hospitals, either specifically, or as part of a broader review of exempt organizations generally.
  1. The House Ways and Means Committee has established an Oversight Subcommittee on Hospital Pricing Practices to determine whether hospitals are sufficiently charitable to warrant continued tax exempt status.
  2. The House Energy and Commerce Committee has established an Oversight Subcommittee on Hospital Billing and Collection Practices. The goal of the Subcommittee is to obtain greater information on billing practices in the healthcare industry and assess the billing inequities faced by the uninsured.
  3. The Senate Finance Committee is focusing more broadly on the tax-exempt organization community in an effort to identify and curb a wide array of abusive practices, including executive compensation, charitable fundraising techniques, insider transactions, financial reporting, board governance, etc. The initial hearing was held on June 22, 2004.
Senate Finance Committee White Paper
As a precursor to the June 22nd hearing, the Senate Finance Committee released a draft white paper prepared by the Committee’s staff, which proposed massive reforms and best practices (consistent with Sarbanes-Oxley) for tax-exempt healthcare providers and other nonprofit organizations. Proposed reforms by the Finance Committee include:

1. General Reforms
  • A five-year review of tax-exempt status by the IRS.
  • Instituting requirements for strong governance and best practices for not-for-profit organizations by:
    • Establishing federal liability for breach of duties by board of directors.
    • Limiting amounts paid for travel, meals, and accommodation.
    • Requiring stricter compensation guidelines.
    • Requiring Boards to establish program guidelines, policies and procedures to be confirmed in the Form 990.
    • Improving quality and scope of Form 990’s and Financial Statements.
    • Making documents available to the public.
    • Revoking charitable status for accommodations to tax shelters.
    • Greater scrutiny on consumer credit counseling organizations
In addition, many of the reforms focused on encouraging strong governance and best practices for exempt organizations as further described below.

2. Board Duties
  • A charitable organization must be managed by its board of directors or trustees. Members must perform his or her duties in good faith; with the care an ordinarily prudent person in a like position would exercise under similar circumstances; and in a manner the director reasonably believes to be in the best interests of the mission, goals, and purposes of the corporation.
  • Compensation for all management positions must be approved annually and in advance unless there is no change in compensation other than an inflation adjustment.
  • The Board must review and approve the auditing and accounting principles and practices used in preparing the organization’s financial statements and must retain and replace the organization’s independent auditor. An independent auditor must be hired by the Board and each such auditor may be retained only five years.
  • The Board must review and approve the organization’s budget and financial objectives as well as significant investments, joint ventures and business transactions.
  • The Board must establish a conflicts of interest policy, disclose the policy in the 990 and require a summary of conflicts determinations made during the 990 reporting year.
  • The Board must establish and oversee a compliance program to address regulatory and liability concerns.
  • The Board must establish procedures to address complaints and prevent retaliation against whistleblowers.
3. Board Composition
  • The Board must be comprised of no less than three members and no greater than fifteen.
  • No more than one member may be directly or indirectly compensated by the organization.
  • Compensated members may not serve as the board’s chair or treasurer.
  • At least one board member or one-fifth of the Board must be independent.
4. Board/Officer Removal
  • Any individual that is not permitted to serve on the board of a publicly traded company due to Federal or State law may not serve on the board of an exempt organization.
  • Any individual that has been criminally convicted of a Federal or State charge of fraud, or similar offense, may not serve on the board or as an officer of an exempt organization for 5 years after the conviction.
Statement of IRS Commissioner Mark W. Everson
The IRS is also developing form changes to focus more specifically on governance questions. The IRS has asked for and received comments from the public on whether Form 990 should require disclosure of whether the organization has a conflict of interest policy or an independent audit committee and whether additional disclosure should be required concerning certain financial transactions or insider relationships. The IRS Form 990 Revision Team is working on a comprehensive overhaul of the form to provide better compliance information about these organizations to the IRS, the states and the public. The IRS is also revising Form 1023, Application for Recognition of Exemption, to provide new focus on governance issues, both in terms of questions that explore compensation setting practices and arrangements and on conflict of interest questions. The form is being expanded to include a sample conflict of interest policy, and other materials to help filers better understand good governance practices.

Class Action Lawsuits Challenging Charitable Practices
Since June 16, 2004, forty-nine class action lawsuits against health systems controlling 250 hospitals in 23 states have been filed targeting the alleged failure of nonprofit hospitals to adequately care for the uninsured. The suits focus in particular upon hospitals’ fee structures and collection practices. Prominent defendants include Sutter Health, one of the largest nonprofit healthcare systems in the country, Advocate Health Care in Oak Brook and Resurrection Health Care, Chicago’s largest Catholic hospital system. The cases generally assert that the defendant hospitals have enjoyed tax-exempt status under Internal Revenue Code Section 501(c)(3) and/or under applicable state law because they explicitly or implicitly promised to provide charity care for the uninsured and would not operate to benefit private interests.

In August, North Mississippi Health Services (NMHS), a 650-bed hospital located in Tupelo, Mississippi, along with five smaller hospitals located in north Mississippi and western Alabama, entered into a settlement agreement with Richard Scruggs, the attorney leading the class actions. Although NMHS was not a defendant in these class actions, according to John Heer, the CEO of NMHS, the health system agreed to the settlement to avoid “the distraction and cost associated with a potential lawsuit of this magnitude.” As part of the settlement, NMHS agreed to refund any amounts paid by uninsured patients who received services during the past three years and who would have qualified for discounts under the revised policy.

More recent developments have favored the defendants. On October 20th, the U.S. Judicial Panel on Multidistrict Litigation refused to consolidate 28 of the class-action lawsuits over hospitals' billing of uninsured patients, a move requested by the plaintiffs. The panel indicated that centralization would neither serve the convenience of the parties and witnesses nor further the just and efficient conduct of this litigation. Then on October 22nd, a judge dismissed the lawsuit against the nine-hospital Baptist Health System in Birmingham, Alabama and the American Hospital Association. The judge dismissed the compliant on the grounds that the charges had previously been tried in state court and that the crux of the suit, the Emergency Medical Treatment and Labor Act, did not apply.

Taxpayer Challenges to Property Tax Exemptions Continue
Following a heated challenge by local taxpayers, on February 13, 2004, the Illinois Department of Revenue ruled that Provena Covenant Medical Center in Urbana was no longer eligible for its property tax exemption and that the hospital was not a “charitable institution” in part, because of its collection practices. Unless the ruling is reversed, Provena Covenant will be required to pay a $1.1 million property tax bill for the 2002 fiscal year.

Similarly, in early October, a Michigan Appeals Court upheld a tax court’s determination that McLaren Medical Management, Inc. (MMM) and McLaren Regional Medical Center (MRMC) were no longer entitled to property tax exemption because they failed to demonstrate that their provision of charitable medical care constituted anything more than an incidental part of their operations. The Court noted that its financial losses from maintaining an open-door policy and accepting an unlimited number of Medicare and Medicaid patients did not render MRMC a charitable institution.  

Conversely, on August 24, 2004, the Cook County Board of Review denied a taxpayer's attempt to challenge Resurrection Health Care's exemption from local property taxes in the county. The board found insufficient evidence to justify a finding that Resurrection no longer fulfills the "legal and factual criteria" necessary to retain its charitable exemptions.