Facing congressional inquiries into their charitable care and spending practices, as well as lawsuits challenging their billing and collection policies for the uninsured, not-for-profit hospitals now face another potential foe: the tax man.
The Internal Revenue Service is unveiling a new enforcement initiative aimed at tax-exempt organizations-including potentially hundreds of hospitals and healthcare organizations-that will be conducted through the agency's exempt-organizations division.
Steven Miller, the newly promoted IRS commissioner for exempt organizations and government entities, said the tentatively titled Compensation Enforcement Project was spurred by growing public and agency interest in the amount of money some tax-exempt organizations are paying executives and how those organizations are reporting that compensation.
Miller said newly strengthened regulations allowing the IRS to impose intermediate sanctions against not-for-profit organizations that run afoul of the tax laws and new data-analysis capabilities have given the agency the tools to undertake the initiative, which it hopes to launch by late June.
The IRS will select the organizations based on gross assets and receipts and comparable compensation, either in aggregate or for a particular executive. In May, Miller told an audience of religious institution executives that the IRS would look at, among other things, organizations that pay an executive more than $1 million. He said the first batch would include 501(c)(3) organizations, such as private foundations and public charities, including hospitals.
"There will be a selection from large and small organizations," he said. "We're not focusing solely on outliers at large organizations. Someone being paid a large amount at a small organization will not slip under our radar."
He said some of the largest tax-exempt organizations are hospitals and health systems.
"If we're looking at the high end of the strata, it's pretty clear to me that we'll be including a number of healthcare providers. What we're hoping to find is that people are looking at our regulations and are complying," he said.
The IRS's new compliance unit in Ogden, Utah, to be staffed by more than 20 revenue agents and tax examiners, plans to send up to 1,000 letters within the next year to exempt organizations. Supporting it will be a new data-analysis unit with 10 economists, statisticians and research analysts using databases to investigate emerging compliance trends. The initiative includes a series of "desk audits," also known as "soft contact" or "office" audits that seek information about how those organizations reported data on their 990, W-2 and 1099 federal tax forms.
Several hundred this summer
Miller said the information gleaned from those audits would be handed to experienced IRS agents around the country. Some might result in traditional tax exams or compliance checks, while others might be purely educational.
"It's going to be launched in stages," Miller said, "with several hundred going out this summer and more to follow, depending upon what we find. We envision this continuing well into 2005."
Presumably, by then, Congress will also have had a chance to weigh in on the issue. Influential members in both chambers have recently called for hearings on whether not-for-profit organizations merit their tax-exempt status. Both Max Baucus (D-Mont.), the ranking member on the Senate Finance Committee, and House Ways and Means Committee Chairman Bill Thomas (R-Calif.) have mentioned the issue as a priority for their respective committees (May 24, p. 4).
Miller said the agency hopes to learn how tax-exempt organizations are setting compensation rates, outline the practices and identify changes in reporting trends.
Federal tax laws governing exempt organizations require that compensation for officers and board members be reasonable and reported correctly. Failure to do one or both can result in penalties, restitution and fines and can jeopardize the institutions' tax-exempt status. The IRS and healthcare tax attorneys advise hospitals to document how they arrived at compensation packages and report those accurately on 990, W-2 and 1099 tax forms.
"We're aware of the inquiry but haven't talked about it with our members yet," said American Hospital Association spokesman Richard Wade. "I don't think anyone should be surprised. You see stories about the United Way scandal and the controversy over (former New York Stock Exchange Chairman Richard) Grasso's compensation and believe that the public has a right to question the definition of not-for-profits and tax-exempt organizations. My guess is we'll see more of this kind of oversight, not less."
Wade said hospitals, as public institutions, are used to this kind of scrutiny and have insulated themselves from potential problems by hiring lawyers and consultants to advise them in their tax preparation and governance policies.
"This will serve as one more reminder to our industry that tax-exempt status has to be earned and is a privilege granted to us," Wade said. "A lot of not-for-profits will be more concerned, mostly small organizations and artistic groups, because they've never had to deal with it before."
IRS officials have said that more than 4,000 exempt organizations left a box unchecked on their 990 tax forms asking whether the organization had reported an excess-benefit transaction, a topic of great concern to the agency. In a recent speech to Washington tax lawyers, IRS reviewer Leonard Henzke said excess-benefit transactions are the most commonly raised issue in tax examinations of exempt organizations.
Henzke explained that if an exempt organization gives an economic benefit to an insider that is not treated as compensation, the IRS will treat the economic benefit as an "automatic excess-benefit transaction," subjecting the officer or director to penalties, interest and restitution of up to 225% of the amount of the benefit.
He said the IRS wants to let organizations know that it is stepping up its policing of such transactions. It will be looking for whether organizations are using standards for comparing the compensation of executives of similarly sized organizations. "We need to see how people are setting compensation," he said.
Healthcare tax attorneys, hospital association officials and consultants said the IRS is sending a message that will reverberate far beyond the fewer than 1% of the nation's estimated 1.8 million tax-exempt organizations targeted in the inquiry.
Wayne Henry, a former IRS lawyer now specializing in healthcare tax issues with the Scottsdale, Ariz., office of law firm Kutak Rock, said the enforcement initiative could have political as well as financial implications for hospitals.
"As congressional hearings begin looking into not-for-profits, having the IRS looking at CEO salaries is going to put further pressure on hospitals," he said. "If they can't defend the reasonableness of compensation, they're going to get pilloried publicly, probably won't try to defend this high pay in the media and will likely settle charges with the IRS. The IRS has a sanction here that has some real teeth."
Henry said hospital boards should be concerned even if they're not the subjects of the inquiries. Items such as gift certificates, season tickets to sporting events and theater tickets aren't always reported by hospitals as income to board members and officers, he said. "This could become an accounting nightmare for some hospitals."
Healthcare tax lawyer Thomas Hyatt of the Washington office of Ober Kaler predicted that if high executive compensation is a criterion for the audits, academic medical centers will be in the IRS' sights.
"It's not unusual to see that kind of pay for some of their superstar clinicians and officers," Hyatt said.
John Self, CEO of Dallas-based executive recruiting firm JohnMarch Partners, said in recent years there's been significant growth in executive compensation at not-for-profit healthcare organizations, with large systems routinely paying $500,000 to $1 million for top executives.
"For somebody managing 10 to 20 hospitals, that kind of money is not out of the question," Self said. While he said the not-for-profits have not matched investor-owned companies in terms of aggressive executive compensation, hospitals that have bought large physician group practices have continued to subsidize doctors through large compensation packages.
A Modern Healthcare report on compensation for tax-exempt healthcare association executives found at least three earning more than $1 million (March 29, p. 26). And a compensation survey of executives at the nation's 235 biggest not-for-profit groups, published last October by the Chronicle of Philanthropy, saw salary increases averaging 4.3% in 2002, despite a shaky economy. The median salary for CEOs was $285,000, but the survey found numerous hospital and healthcare executives earning more than $1 million.
Not keeping up
Donald Wegmiller, chairman of Clark Consulting Healthcare Group in Minneapolis, said boards of tax-exempt hospitals routinely seek comparative executive compensation data from for-profit counterparts to determine whether their compensation packages are reasonable. Wegmiller said the results have remained fairly static. He said while base salaries for not-for-profits are similar to for-profits and even higher in larger organizations, short-term and long-term incentive compensation packages at for-profit organizations are much higher.
"The innuendo that not-for-profit compensation is keeping up with or approaching for-profits is dead wrong," he said. "It just ain't so."
James Unland, a valuation consultant and president of Healthcare Capital Group, said the IRS is ratcheting up the intensity of its focus on excess-benefit transactions and executive compensation within tax-exempt organizations. Comparing salaries of one hospital CEO to another won't be enough to justify large amounts of compensation anymore, he said. Hospitals will also have to start paying attention to the benefits and perks of comparable executives, as well as the relative credit ratings of other hospitals to analyze the value a CEO brings. "The IRS means business and isn't doing this frivolously," he said.
Gerald Griffith, a healthcare tax lawyer with the Detroit office of Honigman Miller Schwartz & Cohn, said the IRS move is "out of the ordinary. It's not an approach the service has taken before." Griffith said the desk audits offer the IRS a way to get "the biggest bang for their buck on compliance."
He said the letters that IRS officials have publicly announced but have not yet issued will demand that tax-exempt organizations take a closer look at their reporting prac-tices with minimal effort and resources. He said the agency will ask whether the organization has taken the appropriate steps to establish what's called the "rebuttable presumption of reasonableness," a formalized process of establishing compensation and the prices paid for goods and services under the IRS' excess- benefit rules.
"They may ask for documentation, including copies of minutes and data for arriving at fair market value," Griffith said. "If in cross-checking tax returns or reading the responses they see something missing, those organizations may get a visit from the IRS."
Todd Greenwalt, a healthcare tax lawyer with the Houston office of Vinson & Elkins, said it's common for hospital boards to sometimes meet at resorts and bring their spouses. That's not a problem as long as the hospital reports that as income, a part of reasonable compensation to the board member. However, if the hospital pays for the trustee's spouse to attend and fails to report it as income, that constitutes an automatic excess-benefit transaction punishable by up to 225% of the value of the trip in penalties, restitution and fines to the director and the organization.
Greenwalt said he expects the IRS will gather the data it's gleaned from the desk audits to create best-practices guidance for setting executive compensation.
"I see this as more of an information-gathering exercise," Greenwalt said. "It's not unusual for them to use something like this as a tool. If they see that most of these organizations are compliant, they may decide to reallocate resources. Conversely, they may discover further problems."