The Internal Revenue Service is ramping up pressure on hospitals and other tax-exempt organizations to prove that theyre not abusing their ability to borrow money in the tax-free bond market.
The IRS in late August sent out more than 200 questionnaires to 501(c)(3) exempt organizations that had bonds outstanding in 2005, a move that puts hospitals in the cross hairs of the tax collection agency. Because those selected likely will be large, capital-intensive organizations, they likely will include a significant number of hospitals and healthcare systems, said T.J. Sullivan, a partner in the law firm Drinker Biddle & Reath in Washington.
The IRS is looking for information on how tax-exempt borrowers are using the proceeds. The questions are intended to measure record-keeping throughout the term that the bonds are outstanding, private activities conducted in bond-financed facilities, and investments that could be used to arbitrage bond proceeds, Sullivan said.
While compliance checks such as these questionnaires are not formal examinations, The wrong answers could trigger additional scrutiny, Sullivan said.
Even hospitals that dont receive the IRS questionnaire should consider filling one out, industry officials say. The American Hospital Association on its Web site announced it would be encouraging hospitals to complete the questionnaireeven if they arent included in the surveyin the event they are audited or examined in the future. The survey will give hospitals a good idea of where they stand with regard to their own compliance efforts and what the IRS is looking for, said Mike Rock, a lobbyist for the AHA.
In that vein, Robert Gill, chief financial officer of HealthEast Care System in St. Paul, Minn., said his hospital system plans on filling out the questionnaire, even though it wasnt sent out to them. This is to give ourselves comfort that if IRS were to ask us to provide more information or audit us, we would know the areas of potential exposure and would be able to create a corrective action plan in advance of subsequent IRS actions, he said.
Gill said that private-business-use activity is something the IRS is most concerned about. Under the arrangements that concern the IRS, a hospital uses tax-exempt bonds to build a wing or whole hospital and then engages a for-profit organization such as a pharmacy or a McDonalds to run businesses out of that space. That hospital would be violating private-use issues of the IRS, which could result in the IRS converting the bonds to taxable bonds, he said.
According to the AHA, the IRS plans to issue a report on the survey findings that includes recommendations for follow-up outreach or compliance. IRS officials were unavailable for comment on the questionnaire.
Another area that the IRS is believed to be targeting is known as bond arbitrage. Tax-exempt bond issuers such as a large hospital or system can borrow money in the municipal markets at a much lower rate than what for-profits pay. The theory is they can potentially use that money to invest in other securities that pay a much higher rate, and as a result receive a profit of millions of dollars for doing essentially nothing.
This practice is another thing the IRS is concerned about, said Robert Fuller, a principal at Capital Markets Management, in an interview.
For tax-exempt borrowing, a no arbitrage law applies, Fuller said. That means when you borrow money tax exempt the IRS wont let you reinvest the bond proceeds at a rate higher than the bond yield. If a hospital were to borrow at a rate of 5%, for example, and then reinvest the proceeds, the reinvestment return would not be able to exceed 5% or whatever the bond rate is, he said.
An example of misconduct is when a hospital borrows money to erect a building and nets $100 million out of a bond issue. The money is placed into a construction fund that earns interest over the next three years, as the building is constructed. The investments you make have to be safe, because people who purchase the securities want you to use this in the manner youre supposed to, Fuller said. Suspicion that this has not always been the case at tax-exempt organizations is the reason why the IRS has issued this survey, Fuller said. And they may have reason to be suspicious. Lots of shenanigans take place in the general municipal market.