The Tax Status of Notfor-Profit. Siege & The Financial Implications of Recent Attacks

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1 The Tax Status of Notfor-Profit Hospitals Under Siege & The Financial Implications of Recent Attacks In a growing wave of litigation and scrutiny, critics charge that modern not-for-profit hospitals and healthcare systems fail to qualify for charitable status under state and federal laws. A battle is brewing over the legal status of not-for-profit hospitals and healthcare systems. The opening salvo was fired in the summer of 2004 when plaintiffs attorneys, led by The Scruggs Law Firm of tobacco litigation fame, filed federal class-action lawsuits in eight states against roughly a dozen not-for-profit hospital systems. Keith Anderson Partner Gardner, Carton & Douglas The suits alleged that the not-for-profit institutions had violated their explicit or implicit contract with the federal government to serve uninsured patients, in return for significant tax breaks. These not-for-profits, the suits claimed, had charged uninsured patients premium rates even though insurers, HMOs and government programs paid steeply discounted rates. Some suits also cited aggressive billing and collection tactics, including placing liens on homes and assessing interest, fines and legal fees. In the wake of this litigation, other parties across the country quickly stepped up their scrutiny of not-for-profit healthcare organizations. Community advocates, state and municipal tax commissions, and state attorneys general all began asking one central question: Are charitable hospitals living up to their stated mission of providing charitable care to all who need and apply for it? George Gevas Senior Vice President / Regional Manager National City It is a multi-faceted onslaught that has been occurring over the last 18 to 24 months, says Keith Anderson, a partner in the Chicago law office of Gardner, Carton & Douglas, a firm whose practice focuses on business, transactional and regulatory matters for not-for-profit and for-profit healthcare entities. What we ve begun to see is a focus on the obligations of not-for-profits, and what they need to give back to the community in exchange for the tax breaks they receive. 1

2 The Background On a Hot Issue Historically, there has been little dispute that not-for-profit hospitals qualify for charitable tax exemption. Typically, hospitals are exempted from federal income tax if they qualify as charitable organizations under section 501(c)(3) of the Internal Revenue Code and provide care to all patients in need regardless of their ability to pay. Likewise, the interest on tax-exempt bonds used to finance not-for-profit hospitals and health systems is not taxable to the bondholder. On the state level, hospital corporations must meet the obligations of their state s not-for-profit corporation acts and, in some respects, their state constitutions. Of course, exceptions have occurred. During tight economic times, taxing authorities notably, in Pennsylvania, Utah and Texas sought new sources of revenue and developed bright-line exemption tests. In several cases, hospitals lost their property tax exemption, for example, when it was determined that they: 1. Served primarily paying patients; 2. Charged services to all patients able to pay; 3. Verified patients financial ability to pay. That kind of scrutiny is, in part, what we are seeing now, says George Gevas, Senior Vice President and Regional Manager of Corporate Banking, National City. Critics charge that modern not-for-profit hospitals and health systems fail to qualify for charitable status because they do not dispense charity to all who need and apply for it, and that they seem more focused on their balance sheet and financial stability. Property Tax Exemptions Take a Hit The 2004 federal lawsuits appear to have piqued the interest of municipal and state taxing authorities, which began questioning the exemption of not-for-profit hospitals from property taxes in several notable cases: Illinois Provena Covenant Medical Center in Urbana became the first not-for-profit hospital in the state to ever be denied property tax exemption, in part because of its overly aggressive attempts to collect money from poor and uninsured patients. The Illinois Department of Revenue agreed with the assessment of the Champaign County Board of Review, which found that the hospital didn't prove that the property was being used in a charitable manner. The loss of its property tax exemption could cost the hospital $1 million a year. Recent actions against not-for-profit hospitals: Federal and state class action lawsuits Challenges to state property tax exemptions Attorneys general investigations IRS investigations and audits Congressional investigation Proposed state legislation Status: Provena has appealed the decision and is currently awaiting a final ruling from the Illinois Department of Revenue. 2

3 Illinois Likewise, in 2004, the Champaign tax board recommended that the state deny charitable exempt status for the Carle Foundation Hospital, Urbana s other main hospital. The recommendation was based on claims that less than.5 percent of its assets and/or revenue were devoted to charity care. Status: Carle Foundation appealed this recommendation with the Illinois Department of Revenue. A decision is pending, depending on the outcome of the Provena case. Ohio In September 2004, the Ohio Tax Commissioner recommended against charitable tax exemption for a family health and surgery center of an academic medical center. Among the factors cited were that less than 2 percent of charitable care was provided to indigent persons or those who could not afford the full cost of care. It was claimed that the property was primarily used to generate revenue. Status: The case was dismissed because property taxes, assessments, penalties and interest sought to be exempted had not been paid in full. But the case was recently re-filed and remains pending. Attorneys General Cite Consumer Fraud Attorneys general in several states have also weighed in, claiming that not-for-profit hospitals are running afoul of contract law by unfairly pricing and billing their services. In Minnesota, for example, the attorney general s office took the view that a two-tier pricing policy existed in that state. The tier one cited was that insured patients were receiving a discount negotiated by their insurance companies or managed care plans. The second tier cited was that in not having access to those same discounts, uninsured patients were being charged full prices. The AG s office made it very clear that it would begin lawsuits unless hospitals were willing to abandon that practice. What Triggers Trouble? Common themes running through these cases include: Substantial profits, but a small percentage of those profits spent on charity care Grants and contributions are a low percentage of gross revenue Extensive screening to qualify for financial assistance programs Failure to advertise charity and financial assistance To date, more than 60 Minnesota hospitals have signed a settlement arrangement and have effectively agreed not to charge uninsured patients who earn less than $125,000 per year anything greater than what they charge their biggest insurance payer. The bottom line is that AGs are comparing notes and considering whether not-for-profit hospitals and systems are delivering on their missions and community commitments, says Anderson. The Minnesota approach has begun to be widely accepted and endorsed by a number of attorneys general around the country. 3

4 Billing Practices Get Blasted In addition to coming after their exemptions from state property taxes, state attorneys general have also turned their attention to what they claim are not-for-profits heavyhanded billing and collection practices. News accounts of elderly persons losing their homes and retirement savings to hospital garnishment actions or liens have only fanned the flames. The AGs and revenue authorities have taken the position that billing every admitted patient constitutes evidence of a non-charitable hospital, says Anderson. So, if an organization s approach to charity care is that everyone is going to get a bill and, once they get the bill, they can come in to talk about potential charity care, the hospital is placing itself at risk of scrutiny. IRS Eyes Executive Compensation A number of hospitals and health systems have also received letters over the past year from the IRS requesting documentation on executive compensation and benefits, deferred compensation plans, and executive contracts. In some circumstances, these soft audits have led to full-blown IRS audits and scrutiny of the entire not-for-profit operation. In addition, there appears to be increased interest by the IRS in joint ventures between not-for-profit hospitals and for-profit or private individuals, including physicians. What Charity Care Is...and Is Not So, just exactly how much charity care is enough? That s a big part of the challenge, says Anderson. There really are no standards for measuring charity care. Some state revenue departments have taken the position that charity care is the only factor in a not-for-profit s exemption analysis. For example, unreimbursed Medicare or Medicaid costs have been deemed irrelevant to the qualification for charitable property tax exemption. In addition, health education activities health fairs, lecture series and screenings have been viewed simply as marketing and public relations expenditures, not evidence of providing charity care. The AGs and revenue authorities have taken the position that billing every admitted patient constitutes evidence of a non-charitable hospital. So, if an organization s approach to charity care is that everyone is going to get a bill and, once they get the bill, they can come in to talk about potential charity care, the hospital is placing itself at risk of scrutiny. - Keith Anderson Gardner, Carton & Douglas 4

5 State Legislators Weigh In As the battle wages on, several states are contemplating legislation that provides more definite requirements for not-for-profit hospitals. Among other things, the Tax-Exempt Hospital Responsibility Act ( TEHRA ) proposed by the Illinois Attorney General would require all tax-exempt hospitals to provide uncompensated care equal to at least 8 percent of their total operating costs, and file an annual charity care report with the AG. The Hospital Fair Billing and Collection Practices Act ( HFBCPA ) would require all Illinois hospitals to refrain from aggressive and harassing collection measures, including refraining from billing patients during the 60-day period post-discharge. Ohio s legislature has had hearings into whether not-for-profit hospitals are meeting their duty to provide charitable care and has explored having hospitals make Payments in Lieu of Taxes ( PILOTS ). In addition, Congress has indicated its intent to reform tax-exempt organization laws that have not been modified since These reforms are likely to focus on transparency, board governance, charity care policies, community benefit standards, and billing or debt-collection activities. U.S. Sen. Chuck Grassley (R-Iowa), Chairman of the Senate Finance Committee, recently stated that he will propose new reforms for tax-exempt organizations, including hospitals, later this year. NFP Litigation The Numbers Efforts to consolidate the more than 75 federal class action lawsuits that were filed during the first wave of litigation were quickly rejected. Twenty-nine federal cases have been dismissed in whole or in part for a variety of reasons, including the conclusion by some federal courts that a private citizen did not have a right to bring a case to enforce the 501(c)(3) section against another private citizen or public not-for-profit hospital. Many of the plaintiffs then dismissed their federal cases in order to preserve their claims and to refile their cases at the state level. A number of those cases are still pending. Some have been dismissed. Some discovery is being permitted in others. Federal Cases 43 Dismissed on Motion to Dismiss 22 Dismissed by Plaintiffs 4 Remanded to State Court 3 Undecided 3 On Appeal State Cases 19 Decisions 10 Dismissed on Motion to Dismiss 9 Dismissed on Merits 1 Dismissed with Leave to Amend 9 Denying, in Whole or in Part, Motions to Dismiss 5

6 Potential Financial Implications The financial implications of a hospital losing its not-for-profit status under state and/or federal law are substantial. A hospital or health system that is suddenly faced with a multi-million dollar tax bill must obviously divert funds away from providing health care services. That could have a direct negative impact on access to, and the quality of, healthcare in a community, Anderson says. That s a big concern because, in many communities, the notfor-profit hospitals are the safety nets. There are very few hospitals today that are county tax-funded. A hospital that loses its 501(c)(3) status could also face serious challenges with regard to any tax-free bonds it issued. Those bonds would become subject to federal income tax that may be retroactive to the date of issuance, says Gevas of National City. Cross default clauses in the financial documents could also trigger default of other tax-free bonds the hospital issued. If the bonds were to become included in gross income, they could be accelerated pursuant to the terms of the trust indenture, or they could be put back by the bondholders to the remarketing agent, Gevas says. Then there is the issue of future bond issues. It is going to be a lot more expensive, borrowing on a taxable basis, for a hospital to put up a new cancer center, expand a campus or add new equipment, says Gevas. It really is a substantial tax liability on income of the hospital, which could have a material adverse effect on the financial condition of the hospital. Fund-raising could also be impacted if a hospital loses its not-for-profit status. Those individuals and institutions that are giving to a hospital are deducting the contributions from their taxes, says Anderson. The philanthropic support may be impaired if the organization loses its tax-exempt status. The Bottom Line Unfortunately, the issue of how hospitals treat the uninsured is likely to continue drawing attention, especially as people experience the high price of health care themselves and become more sensitized to the issue. It s not something that will simply go away, says Gevas. Not-for-profit hospitals need to make sure that they are not only providing charity care but also documenting it and communicating those efforts. Not-for-profit hospitals need to make sure that they are not only providing charity care but also documenting it and communicating those efforts. - George Gevas National City 6

7 Action Steps In light of the heightened scrutiny, not-for-profit healthcare organizations would be well advised to thoroughly evaluate their charity care policies and debt-collection activities. Step 1: Evaluate Your Charity Care Policies Not-for-profit healthcare organizations need to seriously look at their charity care policies when they advise patients of the policy and how they make charity care available, Anderson says. It really becomes a question of, Are you operating in a way that makes you susceptible to scrutiny? Questions to ask include: Has your governing board established a written charity care policy with clear guidelines for determining which patients qualify for charity care? Is this policy consistently applied? Does your organization have a policy for offering discounts or reduced-fee services to uninsured patients who do not qualify for charity care? Does your hospital effectively communicate its charity care and discount policies? Is the amount of charity care provided by your hospital responsive to the needs of your community? Is it consistent with that provided by other hospitals in your area? Step 2: Evaluate Your Billing Policies The American Hospital Association (AHA) has encouraged hospitals to adopt voluntary reforms concerning billing and collection. In evaluating billing and collection policies and procedures, it s important to make your charity care policies known and publicized upfront, Anderson says. Prior to discharge, a patient should be clearly advised of what options are available in terms of charity care, discounts and installment payment mechanisms. Questions to ask include: Has your staff been educated on the hospital s charity care, financial assistance, and billing and collection policies and procedures? Are uninsured patients provided (and informed of) a 60-day stand-still period following discharge, during which time they can apply for charity care? For uninsured patients who do not qualify for charity care, do you offer a patient-friendly billing process and the opportunity to enter into a reasonable payment plan? If your hospital is under an agreement with a debt collection agency, does the agreement permit you to dictate the debt collection practices? Before any legal action is pursued, does your board get involved and approve any post judgment collection efforts? 7

8 About The Experts Keith Anderson is a partner in the Chicago law office of Gardner, Carton & Douglas. His practice focuses on business, transactional and regulatory matters for not-for-profit and for-profit healthcare entities. Keith is regularly involved in negotiating and structuring health industry mergers, acquisitions and joint ventures, and physician hospital initiatives. Keith graduated from George Washington University, J.D., 1982, and DePauw University, B.A George Gevas is a Senior Vice President and Regional Manager of Corporate Banking at National City. George has been lending and providing banking services to the healthcare industry for 25 years, including large and community hospital systems, ambulatory surgery centers, physician practices and senior living facilities. George received his BSBA from Miami University, MBA from Capital University and is a graduate of the Stonier Graduate School of Banking. About National City National City Corporation (NYSE: NCC), headquartered in Cleveland, Ohio, is one of the nation s largest financial holding companies. The company operates through an extensive banking network primarily in Ohio, Illinois, Indiana, Kentucky, Michigan, Missouri and Pennsylvania, and also serves customers in selected markets nationally. Its core businesses include commercial and retail banking, mortgage financing and servicing, consumer finance and asset management. At National City, we offer a range of products and services that make your financial issues easier to manage, and positive results easier to obtain. We pride ourselves on being the best financial institution for corporate banking, and a leader in financial services and banking technology. Our goal is to develop long-lasting, high-quality business relationships based on communication, interaction, knowledge, trust and most important, results. For more information on National City, visit About National City Webcasts Information in this White Paper is extracted from a January, 2006 Webcast entitled Financial Implications of Recent Attacks on Not-For-Profit Hospital Status. A transcript of this Webcast and/or the slides reviewing the Webcast may be accessed at click on Archived Webcasts. National City also sponsors a series of Webcasts conducted by Richard J. DeKaser, Senior Vice President and Chief Economist, National City. DeKaser discusses economic trends and provides analysis. For more information on these and other Webcasts, visit Contact: Keith Anderson (312) kanderson@gcd.com George Gevas (614) george.gevas@nationalcity.com 8 NationalCity.com 2006, National City Corporation