During the July 1991 congressional hearing on the tax-exempt status of hospitals, the Internal Revenue Service was criticized for the lack of a meaningful audit program. IRS officials testified that increases in hospital size and complexity, combined with a trend toward corporate restructuring, had caused them to redesign the audit program for not-for-profit hospitals to use "coordinated examination procedures."
CEP is a comprehensive audit methodology first developed for taxable entities that use a multidisciplinary team approach to examine the nation's largest corporations and their controlled or affiliated entities. The examination is conducted by a team of specialized agents who work under the direction of a case manager. The team has authority to review all books and records, all computer files, and all tax and information returns filed by the corporation and its affiliates. This includes all individual income tax returns filed by people employed or affiliated with the corporation under examination.
The record reflects that the service delivered on its promise to move decisively with CEP in the not-for-profit sector. Of the 95 exempt organizations on which CEP audits were initiated since the program began in 1991, 43 involve healthcare corporations, comprising several hundred hospitals. By the end of 1995, 20 of those cases had closed with an average assessment of $984,000 and an average resolution period of 35 months. This emphasis will continue in 1996 as the annual work plan directs that significant resources be applied to CEP.
The threshold for inclusion in the CEP universe is total assets or income of more than $50 million. Most multihospital systems, having average gross receipts of more than $500 million, easily meet the threshold. In addition, the IRS uses a methodology to identify likely cases. It assigns points for various categories such as total assets, gross revenues, multiple locations and numbers of controlled or related entities.
A profile of the types of issues likely to be reviewed is contained in Hospital Audit Guidelines, a guide for agents that has been made available to the public. Issues include joint-venture transactions (practice acquisitions), private-benefit concerns (physician recruitment, insider loans), income tax, unrelated business income tax, deferred compensation arrangements, fringe-benefit taxation, tax-exempt bond financing and payroll tax concerns.
One recurring and costly problem healthcare organizations have faced in CEP is bringing their section 403(b) tax-sheltered annuity plans into compliance with the tax law. Failure to do so can result in the plan's loss of tax-exempt status and inclusion of the participants' contributions in taxable income.
In 1995, the service opened a voluntary correction program to remedy operational defects without jeopardizing exempt status and without paying large penalties. However, this program isn't available to organizations once they have received notice of an examination.
Healthcare fraud is one of the most explosive issues being looked at under CEP. The recent formation of a Health Care Fraud Task Force, led by the FBI, resulted in interagency training. The task force is looking at specific provisions governing false statements or claims by providers under Medicare, Medicaid and other federal statutes, and other types of healthcare fraud. Equally important is that increased awareness of fraud as an issue in the audit arena, combined with the availability of government resources to deal with fraud issues, make it much more likely that the government will pursue criminal sanctions for fraudulent diversion of charitable funds.
As CEP matures, recurring issues will most likely be spun off to targeted issue exams. Healthcare corporations are already subject to these routine audits, in which a small team of agents focuses on one or more issues. In addition, audits often result from media reports, third-party complaints or interagency cooperation. In the past few years, the service has forged and strengthened cooperative relationships with HHS, the Securities and Exchange Commission and the Justice Department.
CEP presents providers with a significant business challenge. At issue are tax-exempt status of an institution and its retirement plans, benefactor goodwill and tax/penalty liability for the hospital, its staff and its employees.
The stakes are high. In addition to the nearly $1 million average assessment resulting from early CEP exams, one healthcare organization currently is fighting in tax court to preserve its exempt status. Another healthcare organization is the subject of a criminal tax investigation.
CEP will continue as a key compliance tool for healthcare institutions, universities and other large, exempt organizations. Although hospitals and clinics make up only 1% of the nation's charitable institutions, they account for 33% of that sector's total revenues ($242 billion) and 44% of program service revenues ($228 billion). With billions of federal dollars flowing through these institutions, healthcare executives should expect continued, focused oversight.
Healthcare executives also should review recently executed compensation packages in light of the imminent passage of the "intermediate sanctions" legislation. That legislation, giving the IRS an excise tax penalty short of revocation of exempt status, was added as a revenue offset to the "Taxpayer Bill of Rights 2" legislation, a bipartisan measure that is almost certain to pass this session of Congress.
It's important to note that intermediate sanctions will impact compensation deals retroactively. The law will be effective for excess benefit transactions occurring on or after Sept. 14, 1995. A transition rule will apply a rebuttable presumption of reasonableness in favor of the taxpayer to a compensation package entered after Sept. 13, 1995, and before Jan. 1, 1997. However, the arrangement must be approved by an independent board that relies on comparable data and adequately documents its determination within a reasonable period of time after entering the arrangement (generally 90 days). After Dec. 31, 1996, the rebuttable presumption will arise only if the criteria are satisfied prior to the payment of the compensation.
Good business judgment mandates that preventive tax planning be incorporated into normal business practice. Because the IRS' audit cycle is based on returns filed during the past two years, documentation of compensation arrangements and high-profile transactions, such as physician practice acquisitions, is essential.