Hospital executives and board members could pay excise taxes on questionable transactions they approved or benefited from under a final regulation the Internal Revenue Service published last week.
The regulation, which applies to tax-exempt organizations, establishes so-called intermediate sanctions for certain tax-exemption rule violations and took effect in temporary form a year ago (Jan. 15, 2001, p. 8).
The sanctions have largely been ignored by the industry, said Michael Peregrine, a healthcare tax attorney at Gardner, Carton & Douglas, Chicago. Publication in final form, however, could lead to increased IRS enforcement, he said.
"This will make a difference," Peregrine said. "We'll start to see more aggressive enforcement of the intermediate sanctions with a tremendous focus on executive compensation."
The regulation establishes excise taxes as a sanction against managers or board members of tax-exempt organizations who participate in what are known as "excess benefit transactions." Such transactions occur when disqualified persons, such as insiders, receive compensation from the charitable assets of a tax-exempt organization that exceeds the fair market value of the service for which payment is submitted. They usually involve cushy employment contracts or business deals with related parties, such as asset sales at discounted prices or service contracts to hospital executives or board members that were not negotiated at arm's length. Under the IRS rule, those who approve or benefit from such deals face a 10% excise tax on the excess value of the transaction.
The regulation was introduced as part of the Taxpayer Bill of Rights Act of 1996. That sweeping law increased the IRS' legal powers over misuse of charitable funds by tax-exempt organizations.
Until the 1996 law, the only penalty for such deals was stripping a not-for-profit organization of its federal tax exemption. The IRS has been loath to mete out such a harsh penalty for fear of jeopardizing public health or punishing innocent parties through hospital closures, Peregrine said.
The final rule that went into effect last week differs in only minor ways from the temporary regulation issued last year.
For example, government-owned facilities, even if they have tax-exempt status, are exempt from the regulation if certain conditions are met. And organization managers must "knowingly and willfully" approve the excess benefit transactions to be hit with the excise tax.
Hospitals employing good business practices-which include finding comparable compensation data, negotiating at arm's length, obtaining fair market value and documenting the process through board minutes and corporate compensation policies-should not fear IRS scrutiny, most experts said.
The final regulation includes a provision called a "rebuttable presumption of reasonableness," said Daniel Fairley, a vice president and executive compensation consultant with the healthcare group of Clark/Bardes Consulting, Minneapolis. That provision protects hospitals if they support compensation packages with comparable market data or peer analysis and document the process, Fairley said.
"If you've done that, then your decision has to be rebutted by the government, which must come in and prove otherwise," he said. "It's like a safe harbor." The provision gives hospitals a road map to avoid prosecution.
Fairley said those steps will help protect hospitals not only from the IRS but also from increasingly active state attorneys general, one of whom last year unwound Allina Health System, an integrated system in Minnesota accused of abusing its tax-exempt status by overpaying executives and lavishing charitable assets on executive perks and travel (July 30, 2001, p. 4).
Marcus Owens, a healthcare tax attorney with the Washington office of Caplin & Drysdale and the former director of the IRS' exempt organizations division, said versions of the regulation have circulated since 1996.
"If you paid attention to those then, you would not be surprised by the final regulations now," Owens said.
He said the IRS drew blood last January with the case of a Mississippi home health provider, Sta-Home Health Care Agency. Owners transferred the assets of three not-for-profit agencies to corporations they owned and converted the agencies to for-profit status. The IRS, however, disagreed with their valuations of the assets and valued the assets of each agency at more than $5 million, assessing taxes in the millions of dollars against the owners, Owens said.
Doug Mancino, a tax attorney with McDermott Will & Emery in Los Angeles, predicted hospital board members will need a heightened sensitivity.
"We'll see an even greater level of attention to process requirements with this potential threat of sanctions out there," Mancino said. "They will want to make sure their policies are in conformity with the rebuttable presumption of reasonableness. And I think IRS agents will feel more empowered to look carefully at questionable transactions. Once a few cases are out there, you'll start to see the scare effect."