When the Internal Revenue Service recently decided to yank the 42-year-old federal tax exemption of a not-for-profit hospital management company, the agency sent a strong message to others in the same business: No one is immune from revocation.
The IRS pulled the tax exemption of Phillipsburg, Kan.-based Great Plains Health Alliance in March, saying in a legal opinion that managing hospitals is not in itself a charitable activity (June 8, p. 2).
Great Plains, which manages or leases 26 hospitals in Kansas and Nebraska, has appealed the revocation to federal tax court.
In taking its action against Great Plains, the IRS made a clean break from its historically sympathetic policy toward rural healthcare organizations.
"You may think that because you operate in a favored area (like rural healthcare), you can do anything you want," said Gerald Peters, a tax attorney with Latham & Watkins in San Francisco. "But this shows you still have to follow the rules."
The agency contends Great Plains had deviated from its religious roots and was simply in it for the money. In its 1996 return, Great Plains reported a $461,557 profit on total revenues of $2.3 million, which translates into a whopping profit margin of nearly 20%.
The IRS declined to comment specifically on the case, brought to light last week by MODERN HEALTHCARE, for confidentiality reasons.
"It seems like we're dealing with the question of public policy and support for healthcare in rural America," said James McGovern, a principal at KPMG Peat Marwick in Washington and a former IRS attorney who oversaw tax-exempt organizations. "Historically, the IRS has been more liberal in applying the private inurement rules to rural hospitals."
On the surface, Great Plains appears to be an unlikely revocation target. The company was formed in 1950 as an outgrowth of the American Lutheran Church's efforts to promote rural healthcare. The IRS blessed its tax-exemption application in 1956.
A member of VHA, an alliance of not-for-profit hospitals based in Irving, Texas, Great Plains manages 16 hospitals and leases 10. Half of them are in medically underserved areas. Great Plains does not own any hospitals.
Roger John, president and chief executive officer of Great Plains, said most of the company's annual profits are spent on providing new management services such as physician-credentialing verification and billing-code consulting services.
"What makes this (Great Plains) case notable is that the organization principally provided managerial and administrative services to rural, tax-exempt, less-than-50-bed hospitals," McGovern said. "These hospitals were small, rural hospitals that truly needed management services so they could fulfill their charitable purposes."
The case is particularly surprising because the IRS has been busy trying to remake itself into a citizen-friendly agency, following heated congressional hearings and passage last month of a bill to overhaul it.
"All of a sudden you see the revocation weapon being wielded more often than in prior years," said Michael Peregrine, a tax attorney at Gardner, Carton & Douglas in Chicago, referring to two pending tax cases in Alabama and Florida. "It's unusual in a sense that we've gone a long, long time without seeing revocations. This tells people that it's a legitimate threat."
For the past 25 years, rurally focused not-for-profits have enjoyed favorable treatment by the IRS, said the agency's Marvin Friedlander, chief of the technical branch of the exempt organizations division. He agreed to comment generally about IRS policy.
One example of this favorable policy is a 1973 revenue ruling that said providing office space and facilities to attract physicians to rural areas did not threaten an organization's tax exemption as a public charity.
More recently, a 1997 revenue ruling said providing specific incentives to physicians can further the charitable purpose of a rural hospital, echoing the 1973 ruling, as long as the incentives don't violate the federal Medicare and Medicaid kickback statutes. Those statutes bar any form of remuneration to induce the referral of Medicare or Medicaid patients.
"The IRS basically said the need was so great (for health services in rural areas) that this would not be a private benefit but a community benefit," McGovern said.
The community-benefit standard, in place since 1969, requires tax-exempt healthcare organizations to provide certain benefits to their communities. Those benefits include teaching and conducting research, maintaining an open medical staff, keeping emergency departments open to all patients without regard to their ability to pay, and accepting Medicare and Medicaid patients.
"Generally, management services are not considered exempt," Friedlander said. "A tax-exempt hospital can provide management services like personnel or data services to smaller hospitals."
Congress even recognized the charitable value of providing management services to small hospitals in a 1976 amendment to the federal tax code. The amendment created an exception from the unrelated business income tax for such services furnished to hospitals that serve no more than 100 inpatients.
"In my judgment, the IRS stretched to reach its adverse position (in the Great Plains case)," McGovern said. Considering the 1976 amendment, the IRS could have maintained the organization's exemption by liberally interpreting the 1997 ruling to say that Great Plains was furthering the charitable purposes of the hospitals it served, he said.
Great Plains' John said even if the company loses its fight for exemption, it will remain a not-for-profit.