Tax-Exemption and the Growing Threat to the Community-Not-for-Profit Hospital

ABSTRACT Most Americans receive their care at the local not-for-profit hospital. Historically, the not-for-profit hospital has been able to avoid federal and state taxes by meeting the ambiguous and subjective charitable purpose standard with relative ease. Continuing revenue shortfalls have prompted local and state authorities to challenge and redefine charitable purpose in both the legislature and the judiciary. A related and recently released Internal Revenue Service Field Service Advice Memorandum concurs, stating that health care organizations must quantify and document the provided. This more costly definition of is critical because it comes at a time when hospitals are facing dwindling revenues. This paper examines the development of federal tax-exempt status for not-for-profit hospitals, with specific emphasis on the evolving standard. The paper also explores state efforts to require hospitals to quantify and demonstrate benefit. The potential impact on the tax-exempt not for profit hospital is discussed. INTRODUCTION Most Americans receive their medical care at the local hospital (1). More than eighty percent of hospitals are organized as not-for-profit organizations (American Hospital Association, 2002). Historically, not-for-profit hospitals have been funded by charitable contributions and operated for charitable Charitable purpose and its more recent manifestation, benefit, provide the basis for exemption from federal and state taxes. Under section 501(c)(3) of the Internal Revenue Code and similarly modeled state tax codes, an organization may be exempt from taxation by meeting certain requirements. For example, a church will be tax-exempt because it furthers a religious purpose. Similarly, a college will be tax-exempt because it furthers an educational purpose. Surprisingly, however, a hospital will qualify for tax-exempt status only if it meets the requirement to further certain charitable purposes. While the promotion of health is within the scope of activities for which tax-exemption has been granted, a hospital does not automatically qualify for the exemption merely because its stated purpose is to promote health. With the development of private insurance in the 1950s and government programs such as Medicare and Medicaid in the 1960s, the importance of philanthropy as a revenue source has declined significantly. Moreover, with the shift to managed care, the development of integrated delivery systems, and a growth in the number of uninsured, the sophisticated hospital of today bears little resemblance to the hospital of the 1970s (Uninsured in America, 2000). These changes have precipitated a similar evolution in the definition of the standard with the identification of community and the nature and extent of benefit left to the interpretations of Internal Revenue Service, the courts, and state taxing authorities. This evolving definition has generated considerable uncertainty and apprehension in the not-for-profit sector as hospitals contemplate potential challenges to their tax-exempt status. This paper examines the development of federal tax exemption and the evolution of the standard. Included is a brief overview of tax-exemption benefits, a review of pertinent IRS regulations, rulings, and memoranda related to the development of the standard, and an examination of state actions relevant to tax-exemption of not-for-profit hospitals. The paper concludes with a discussion of the evolving standard and its implications for the not-for-profit hospital. BENEFITS OF TAX EXEMPTION The benefits of tax-exempt status can be significant (Copeland & Rudney, 1990). In addition to exemption from federal income tax, a variety of state and local benefits are available to tax exempt hospitals, including exemption from state income tax, exemption from state property tax, exemption from state sales tax. …