Allegedly lucrative deals with physicians, excessive executive compensation and extravagant spending on personal items have landed a former operator of a Florida hospital in trouble with the Internal Revenue Service.
In fact, the company is the long-anticipated first casualty of the agency's 4-year-old systematic audit program of not-for-profit organizations, including many hospitals and hospital systems (See related story, p. 22).
As IRS officials warned about the possibility of revoking a not-for-profit hospital's tax exemption over the past few years, tax observers have speculated about the identity of potential targets.
The identities of the operator, the hospital and the not-for-profit organization that allegedly mishandled the proceeds of the hospital's sale to a for-profit chain were contained in federal court and tax documents obtained last week by MODERN HEALTHCARE.
The operator is a Miami-based firm called LAC Facilities, formerly known as Modern Health Care Services. (The company is unrelated to MODERN HEALTHCARE magazine.) Its tax dispute stems from the 1984 sale of 359-bed North Miami (Fla.) General Hospital to Health Resources Corporation of America, a for-profit chain that's now part of OrNda HealthCorp.
There will be a collective sigh of relief from many hospital executives when they learn it's not one of their facilities, said Robert Louthian, a tax attorney with McDermott, Will & Emery in Washington.
Mr. Louthian and Elizabeth Mills, a tax attorney with the firm in Chicago, reviewed the court and tax documents at MODERN HEALTHCARE's request.
Allegations of misuse. The dispute involves allegations that LAC Facilities, when it was Modern Health, squandered the bulk of approximately $57 million it received in proceeds from the sale to Health Resources rather than spending it appropriately on other charitable healthcare services. The book value of the leftover assets was about $250,000, according to one IRS document.
Citing confidentiality restrictions, IRS officials declined comment.
But the company's attorney, Robert Cadle of Fordham & Starrett in Boston, said the agency's case is baseless.
"The facts do not support the IRS' findings and conclusions," he said.
In addition to the firm's likely being the IRS' first revocation victim, the case is noteworthy given the current flood of acquisitions of not-for-profit hospitals by for-profit chains.
What the leftover charitable foundations and not-for-profit corporations do with the money from the sales of their hospitals has been the subject of growing controversy as chains gobble up facilities from organizations that want to get out of the hospital business.
In August, for example, a community group in Salt Lake City criticized Holy Cross Health System Corp., a South Bend, Ind.-based system, for not leaving in the community enough money from the sale of three Holy Cross hospitals in Utah to Healthtrust (Aug. 22, p. 7).
And last year, Adventist Health System/Sunbelt agreed to donate as much as $1.7 million to a new foundation and trust fund to ensure that the community of Punta Gorda, Fla., would benefit from the sale of an Adventist hospital there to what was then Columbia Hospital Corp. (April 19, 1993, p. 12).
Auditors attracted.In the case now pending before the U.S. Court of Federal Claims in Washington, it's the $57 million Modern Health received from Health Resources that brought IRS auditors down on the 33-year-old not-for-profit organization.
Modern Health opened North Miami General in 1961 and ran it as a not-for-profit institution for the next 23 years.
In 1984, it proposed to sell the hospital to Health Resources, a Houston-based chain headed by controversial healthcare financier LeRoy Pesch, M.D.
The deal went through, Health Resources merged with Dallas-based Republic Health Corp., and Republic closed the hospital in 1990 because it didn't meet state and local building codes (See chronology, p. 3).
The old hospital building is now a cooking school operated by Johnson & Wales University of Providence, R.I., which bought the facility for $2.9 million.
But before the sale to Health Resources, North Miami General asked the IRS to clear the leftover organiza-tion's plans to develop a tax-exempt alternative delivery system with the proceeds from the sale.
The organization, which changed its name to Modern Health from North Miami General, wanted clearance to develop a series of primary-care clinics in the Miami area.
In a Feb. 2, 1984, private-letter ruling, the IRS approved the plan.
The hospital sale went through, and Modern Health received its money and designation as a 501(c)(3) organization.
Organizations with that designation are considered tax-exempt public charities that don't pay any federal income tax, are able to accept tax-deductible donations and can arrange tax-exempt financing to raise capital.
Over the next four years, Modern Health went about building its alternative delivery system, dubbed the Institute of Medical Specialties. It was headquartered in a Miami office building and, by 1988, operated 11 satellite offices in the Miami area.
Modern Health built the system by purchasing or entering into service contracts with physician group practices. The organization acquired at least six practices for $13.3 million. The exact number of physicians in the groups wasn't available at deadline.
Modern Health and its five-member board of trustees also formed an offshore captive insurance company to sell malpractice insurance to its physicians.
Certain officers and trustees of Modern Health also formed a limited partnership that contracted with Modern Health to study the feasibility of developing an adult congregate living facility.
But, according to court documents, things didn't go well financially, and Modern Health sold the remaining assets in 1992 to a limited partnership formed by 13 of its physicians and several other investors for a $4.5 million promissory note.
One IRS document said the true value of the assets was $253,614 because collection on the note was "doubtful."
In a countersuit filed against the IRS on Sept. 14, the company, by then known as LAC, blamed its failure on changes in the reimbursement climate, particularly Medicare and Medicaid.
"Because of the changing healthcare environment, including rate reductions by Medicare and other third-party payers, (and) without any reduction of Modern Health's expenses, the institute was not successful economically," it said.
But after an extensive audit, which Mr. Cadle said lasted from July 1990 through October 1992, the IRS disagreed, concluding that Modern Health misspent its money by overpaying physicians and executives, who allegedly benefited at the expense of a public charity.
Under the federal tax code, the earnings of a tax-exempt organization can't inure to the benefit of private individuals, and the activities of a tax-exempt organization can't be conducted for the benefit of private individuals.
After an extensive audit of Modern Health that was touched off by a review of its 1988 federal tax filing, the IRS concluded that the organization violated both prohibitions and more.
The agency's conclusions are contained in what's called a "technical advice memorandum." The IRS typically releases edited memorandums long after they're issued to the parties involved in order to provide unofficial tax guidance.
MODERN HEALTHCARE obtained a copy of the Miami memorandum and a key that identifies all the organizations and individuals cited in the edited document.
The IRS has yet to release the memorandum, dated April 14, because the company sued the agency in an attempt to preserve its 501(c)(3) status. The suit was filed in the U.S. Court of Federal Claims in Washington.
The company filed suit after exhausting its internal administrative appeals with the IRS, Mr. Cadle said. The appeals include six separate submissions of more than 100 additional documents from November 1992 to February of this year.
Many violations. In the memorandum, the IRS concluded that Modern Health violated the inurement and private-benefit prohibitions in numerous ways between 1984 and 1988.
One major inurement problem was allegedly overpaying physicians for their practices to retain their loyalty and patient referrals, the IRS said.
For example, Modern Health allegedly acquired one practice in 1986 for $6 million, although the value of the practice's tangible assets was less than $200,000, the IRS said.
Another inurement problem was the alleged jump in salaries that physicians enjoyed after they became employed or affiliated with Modern Health, the IRS said.
For example, five physicians who contracted with Modern Health were paid $2 million in compensation in 1987, compared with earning a little more than $1 million in 1985, when they were practicing on their own, according to court documents.
"Of interest to many hospitals is the IRS' analysis of the physician practice acquisitions," Ms. Mills said. "They looked for a `bump' in physician compensation following the acquisition."
Directors, officers and trustees of Modern Health also benefited directly from their relationship with the former hospital operator, the IRS said.
In addition to receiving $266,667 in salary from Modern Health in 1988, the organization's president and chief executive officer, Howard Lawn, received a lump-sum distribution that year of $1.8 million from an executive retirement plan, the IRS said. Mr. Lawn was executive director of the old hospital.
He also drew another $120,000 in compensation in 1988 from his post as president and CEO of the organization's insurance company, the IRS said.
Modern Health paid Richard Gubner, M.D., one of the organization's five trustees, a $48,000 consulting fee in 1988 as well as a lump-sum distribution of $755,049 from the company's retirement plan, the IRS said.
Modern Health paid Lloyd Starrett's law firm $451,831 in 1988 for legal services, the IRS said. Mr. Starrett was a board member and law firm partner.
Several executives and board members formed a limited partnership that provided consulting services to Modern Health on the development of an adult living center, the IRS said. The partnership's expenses of more than $90,000 were paid by Modern Health as interest-free loans, the agency said.
And, Modern Health made a number of suspect purchases in 1988 totaling more than $25,000, the IRS said. They included airline tickets for spouses; wedding gifts for employees; china; crystal; glassware; theater tickets; perfume; and more than $8,000 in liquor.
In a letter dated June 16, the IRS notified the company that it was revoking its tax-exempt status retroactive to Oct. 1, 1985, and it was liable for any federal income taxes due.
In its lawsuit, the company said its tax exemption shouldn't be revoked because it complies with the requirements of its 501(c)(3) status by providing charity care, accepting Medicare and Medi-caid patients and offering free and low-cost community health programs.
It said the money paid for physician practices and salaries was negotiated at arm's length and reflected fair if not less than market value (See chart, p. 2).
The salaries enjoyed by its executives were reasonable given their responsibilities and executive compensation levels at comparable organizations in the market, the suit said.
And, it said the suspect expenditures were allowable under the tax code as "ordinary and necessary business expenses in the course of its operations."
The federal claims court has yet to set a trial date in the case.
Mr. Cadle said the former officers, directors and trustees of the organization aren't expected to face any personal tax liability because of the proceedings. He said the IRS has made no claims against individuals.
Regardless of how it turns out, the case demonstrates the dangers inherent in a healthcare facility that's controlled by a handful of people, Mr. Louthian said.
"Close control by physicians or, as in this case, other interested persons, leaves the organization open to IRS attacks on all transactions that directly or even tangentially benefit those in control," he said.