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AHLA's Speaking of Health Law
Top Ten IRS Audit Risks for Nonprofit Health Care Organizations
Gerald Griffith, Partner, Jones Day, and Stephanie N. Switzer, Senior Counsel, Cleveland Clinic, discuss, in top ten style, common audit risks for nonprofit health care organizations and strategies for minimizing potential tax exposure. Gerald and Stephanie spoke about this topic at the 2024 Annual Meeting in Washington, DC.
Learn more about the 2025 Annual Meeting in San Diego, CA here.
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Speaker 2:Welcome to this episode of ALA's speaking of health law. My name is Jerry Griffith and I'm a partner in the healthcare and tax practice groups at Jones Day, working out of our Chicago and Detroit offices. With me is Stephanie Switzer, senior Council at the Cleveland Clinic. Today we're going to talk to you about the top 10 IRS audit risks for nonprofit healthcare organizations, which is a reprise of our session at the 2024 annual meeting in dc . We want to focus on risk areas here at a high level without getting too far down in the weeds and not totally geeking out on the tax code
Speaker 3:<laugh>. Um, hi everyone. My name is Stephanie Switzer. I'm happy to be here speaking with Jerry . As he mentioned, I'm senior counsel at the Cleveland Clinic. I'm also practice area chair of the Nonprofit and Reimbursement Group. And , um, just want to be clear that my comments today , um, and my opinions are my own and they do not reflect that of my employer onto more , uh, interesting items. Jerry ?
Speaker 2:Yes, and first of all, likewise, my comments today represent my views, not necessarily the views or positions of Jones Day or any of our clients. So , uh, why does the IRS audit nonprofit healthcare organizations you might ask? Well, when he was asked, why do you rob banks, Willie Sutton famously said, because that's where the money is, and that's a big part of the reason why the IRS audits healthcare organizations. The other part, of course, is compliance based and , uh, based on, and to some extent growing out of congressional mandates , uh, such as the requirement to review community benefit activities of every nonprofit hospital every three years .
Speaker 3:Yes, and there has been increasing congressional scrutiny recently , um, particularly 20 23, 20 24, on whether tax exempt hospitals are doing enough to justify the tax breaks they receive . That's not a new question, but it's , um, renewed focus. Um, the Congress has also been specifically questioning formally whether the IRS is doing enough to make sure that nonprofit hospitals are following the rules. Um, and with the , um, tax and Jobs Act expiring in 2025 , uh, we can probably expect some, the new tax legislation , uh, would be an opportunity for Congress to consider changes for tax exempt organizations as well .
Speaker 2:Uh , Stephanie and I had a fair amount of back and forth on how we should order this list, perhaps the most famous top 10 lister. David Letterman would start at number 10 and work his way up to number one. Today we're going to start with two long running hot topics on audit. Both UBIT and worker classification are relatively non-controversial, and both issues usually produce some tax dollars on audit. So first up, unrelated business income tax or ubit is a lucrative area for the IRS and if you file a substantial refund claim, you can expect an audit to verify the claim. Section five one C3 and C four . Organizations such as nonprofit hospitals and HMOs are subject to tax on any unrelated business income or UBI. To have UBI, you need a trader business that is regularly carried on with an intent to profit, and the activity is not substantially related to furthering your particular exempt purposes. For healthcare organizations, that frequently depends on whether the activity involves provision of services or sales of items to the organization's patients . There are several exclusions that may apply, including dividends from a corporation, rent from real property royalties and interest subject to limitations for debt financed income and controlled entity payments. UBI is taxed at the current corporate rates , so 21%, and if the unrelated business activity is substantial, it can jeopardize exemption. There are two red flags that draw particular attention from the IRS first. If you report zero UBI and you are a large nonprofit healthcare organization, the IRS is going to be suspicious. They will look for areas that frequently yield UBI such as lab services for private practice patients, retail pharmacy, sales and management services, such as physician practice management.
Speaker 3:Yeah, and Jerry , I think that's a really good point , um, for particularly for smaller organizations. Um, if you have, if there was a lab and a pharmacy in your hospital , um, there probably is some UBI in there somewhere. Uh, so I have heard tax professionals stay , um, sometimes when starting with a new organization organiz , that they were told there isn't any <laugh> . Um, it's always worth double checking.
Speaker 2:Absolutely. And the second red flag, if you have losses year after year, the IRS is likely to question the profit motive. If there is no intent to make a profit, then the expenses would not be deductible and there would be no losses to carry over and apply to any profitable years. Exempt organizations are also disadvantaged in the UBI area by the siloing rules for tax years beginning on or after January 1st, 2018. Net operating losses or NOLs generated in one trader business can be used to offset gains only in that same trader business under section five 12 a six using the two digit North American industry classification system codes. Some common UBIT silos for hospitals include reference lab services for non-patients retail such as retail pharmacy or gift shop sales to non-patients and investments.
Speaker 3:Yeah, and Jerry , this is an area where I , I will say that it feels like exempt organizations are in a bit of a catch 22. Um, the rules seem a little unfair, so if you are an exempt organization and you're not successful in your for-profit business, as you said, the IRS will question the profit motive. If you, if they think you don't have a profit motive, then you must not be running , um, a for-profit business. But , um, if you have several , uh, maybe not, but, and if you have several , uh, for-profit , um, unrelated business activities, you can't consolidate losses in the way that other for-profits can. So it's a little bit of a, of a double whammy.
Speaker 2:Exactly. Uh , issue number two on our top 10 list worker classification, this is another big dollar area for the IRS. In addition to the employment tax that may be due. Reclassification of workers could affect what benefit plans they're eligible for. It really can be low hanging fruit. If you have the same individual receiving both a 10 99 and a W2, the IRS is going to assume that one of those is wrong and that all of the services were provided as an employee. In addition, there are three types of services where the IRS frequently assumes the workers are employees, including medical directors, clinical care personnel, and instructors like yoga instructors. It doesn't mean the IRS is ripe . That's their mindset going in. Uh, there is a planning opportunity here if you don't want to or can't employ a physician, for example, because of the corporate practice of medicine doctrine, you may want to contract with and pay the physician's practice entity, and that entity is then likely to be the employer, even a solo pc, as long as you respect the corporate formalities and the PC's right, to control the performance of the physician.
Speaker 3:Yeah , uh, I think that's a really great point in terms of planning Jerry , but also I, I would encourage folks to really focus on educating independent contractors at the time you're entering into an agreement with them. Um, you know, you mentioned yoga instructors. Healthcare now is much broader from a preventive perspective. There's all kinds of folks who may be , uh, working , uh, with your hospitals , um, on a one-off basis. And, and the reason it's important to educate them at the time of entering into that independent contractor agreement is because it's important to remember that an individual can petition the IRS any time for a change in classification by filing the form SS eight. And as the organization, you're only gonna find out after , um, after the fact, after the IRS has looked into it. Um, it's also very in important to consider these worker classification issues, you know, with the rising use of staffing agencies in , um, hospitals across the country.
Speaker 2:Thanks, Stephanie. Uh, moving on to issue number 3 5 0 1 R compliance. We've had 5 0 1 R audits going on for several years now, looking at essentially the process around how nonprofit hospitals fulfill their community benefit mission. Recently, the IRS started auditing hospitals for the actual community benefit they provide. Stephanie, how do you see that playing out?
Speaker 3:Yes. My understanding is that there are at least 35 such audits going on now across the country. Uh, these are not full-blown via , um, the, you know, full blown TEGE type audits. Um, but rather they are full-blown vis-a-vis 5 0 1 R as the reporting standard for community benefit compliance, meaning formal information document requests, and some onsite visits to hospitals and emergency departments to to verify signage, to verify that employees know how to share information about financial assistance policies with , um, visitors and patients. So that's very different from the IRS compliance check questionnaires that we saw in recent years on 5 0 1 R , um, which you literally, you know, you got something in the mail, you filled it out and send it back, or the desk audits. Um, as Jerry mentioned at the start, the IRS is required to check every , um, nonprofit tax exam hospital for compliance every three years. And, you know, one wasn't even necessarily aware that that check was going on. This is really kind of a new special focus, likely in response to those congressional ques requests , um, to the IRS to really , um, examine what hospitals are doing that. I mentioned earlier
Speaker 2:That that's right, and in these audits, the IRS is , uh, likely to want to walk around, ask for copies of the policies, the financial assistance policy, for example. Uh , this is nothing new in approach. They used to do tours, for example, for single hospital audits and , um, uh, I've also seen that recently for non-healthcare organizations. They're getting back to walking around the physical facilities. When you're doing that, it can be helpful to have an emergency physician along to explain what's happening where in, in the ED space , uh, particularly how patients are taken care of first and any financial discussion happens later.
Speaker 3:Yes. And , um, just, you know, a quick refresher on 5 0 1 R compliance , um, uh, a nonprofit tax exempt hospital has to conduct A-C-H-N-A every three years post it and its implementation strategy , um, publicly widely publicize their financial assistance policy and have a plain language summary , uh, not charging more than what we refer to as the amount generally billed, which is based on both governmental and, and commercial payer , um, amounts, and engage in no extraordinary collection actions without having , um, the person have the opportunity to apply for financial assistance and verifying that person's ability , uh, I'm sorry, eligibility for financial assistance. Um, a little tip on the widely publicized point. If you personally, as a, as a employee of your organization, can't find the financial assistance policy or the CHNA easily on your organization's website, assume that means the IRS can either, and that's not a good thing. Um, of course, schedule a h of the nine 90 is the place where all this 5 0 1 r compliance is reported , uh, since the nine 90 was revamped back , um, in 2008, remember, it's really important to tell your story there. There's an opportunity for , um, text conversation as well as numbers and, and check boxes, yes or no. Um, stories that nonprofit hospital has are , are , are good ones, and it , that story needs to be told not just for the IRS, but for the public at large. Um, remember also that this doesn't just apply to your , um, fully owned hospitals. If you operate joint venture hospitals, those may be subject to 5 0 1 R two . So if you retain sufficient control for your share of the income to be treated as exempt income, then your joint venture has to comply with 5 0 1 R . That means having both a financial assistance policy and conducting CHNAs every three years , um, basically all the 5 0 1 R rules, but specifically those, if you don't have sufficient control to require the joint venture to comply with 5 0 1 R , um, then, you know, the flip side of that is your distributions are UBI. Um, important also to remember that , uh, one of the requirements in 5 0 1 R is, is translation and making policies available , available to the community , um, in which your organizations sit. So since demographic in your community may change over time, it's a good idea to reverify annually or at least every couple of years, whether there are , um, growing , uh, non-English proficient populations that have crossed over the threshold, which is over a thousand persons or, or 5% of the population , um, because you're required to translate your FAP as well as the application form the plain language summary into those additional languages. Um, let's move on to community benefit. So this is the, the next step, kind of, I guess, in the evolution of 5 0 1 R audits. Um, we wanna talk about how you measure community benefit and what the IRS is looking for in , um, its current audit project. The IRS is required to report annually to Congress , um, and conduct those, those audits that we talked about before. Um, for over three thou 3000 exempt , uh, hospitals across the country, that means they're looking at about a thousand hospitals a year to keep up hospitals or hospital systems. Uh, schedule H of the nine 90 is of course the place, as we discussed, where all this compliance is important, and you can tell both that qualitative story that I was talking about , um, for the public at large, for the IRS , um, and also remember that other groups are looking at that , uh, consumer watchdog groups, state attorneys general , um, but organizations like Low , uh, that Jerry's , uh, gonna maybe , uh, mention in a little bit. But quick refresher on community benefit. Uh, the community benefit standard is still alive and well. It's still the facts and circumstances test under revenue ruling 69 5 45 , and it is qualitative , um, that is whether the organization promotes the health of the community as indicated by , uh, a number of factors, including having a community board, having an emergency room open to all the nine 90 reporting is the qualitative, I'm sorry, the quantitative, the numerical part of the community benefit test. It was adopted for better transparency and consistency in reporting among hospitals about what they were spending on their communities, and that includes a number of areas, charity care subsidized health services, Medicaid shortfall research, meaning medical research, medical education, community health education, also community building and community health improvement. An important note on subsidized health services. This is one that, you know, may be really important to dig deeper to see how much your organization is providing because it's less easy to find in the financials. For larger organizations in particular, your clinical staff is focused on doing what is needed , uh, following up on those needs of the community health needs assessment, not waving a big flag when , um, you know, their particular area or or department is losing money. Um, the a HA has a nice list online of the top 10 service lines that are likely to be loss leaders, both in the outpatient and the inpatient setting. Um, that's called cost of caring. If you take a quick look at the a HA website , um, another couple pointers are, make sure you're accounting both direct and indirect costs , um, for subsidized health services, for example, but also in, in many of these other areas , um, research, education, et cetera. And lastly, just make sure those community bene , uh, community activities you're reporting in terms of community health, they have to be tied to a community health need that was reported by your organization in order to count in that care category.
Speaker 2:Congress has been busy with the elections, of course, this being shortly after election day. Uh, but the criticisms of the nonprofit hospital industry and whether it provides enough community benefit to justify tax exemption is still an issue and one that's likely to continue in the next Congress. We have nothing new from the Lown Institute since their report a few months ago, focusing on the amount of community benefit being provided using their own particular definitions. Uh, the story that Schedule H tells, as Stephanie alluded to, could be improved for many hospitals by including statistics and plans for population health management to , uh, reduce infant mortality, combat chronic disease, improve the overall wellbeing of the community, and tackling social determinants of health, the value of which arguably far exceeds the cost.
Speaker 3:Yes, very good points. Um, I also just wanna mention , um, with regard to community benefit and , um, status as a charitable organization, it's really important to remember that your local state tax status , um, uh, is tied to similar factors and sort of a similar analysis to what it means to be a charity under federal law, but they are clearly not the same, and they vary , um, in each state real estate tax exemption requirements generally , um, are based on being a charitable organization and using the property for charitable purposes, but each state has its specific test . Um, it's interesting. Last, and , and just in this past year , um, the state of Pennsylvania had a case called the Tower Health Systems , uh, case relating to real estate tax exemption. There were four related cases in which a Pennsylvania Appeals court denied property tax exemption for some of those tower health system hospitals. Uh, the judge specifically commented that the CE o's salary was quote , eye popping end quote , and that excessive compensation is not consistent with charitable status. Under that case, the organization must operate entirely free of profit motive , and that kind of comp in , uh, the judge's view was not consistent. Jerry , that brings us into our next top 10 item.
Speaker 2:Yes, listeners, you guessed it . It's time to talk about excessive compensation.
Speaker 3:<laugh>,
Speaker 2:One of the dangers with compensation decisions from an audit perspective is what we call the lake wo be gone effect in the immoral words of Garrison Keeler , welcome to Lake, wo be gone , where everyone is above average. Somebody has to be number one even in Lake Wobegon, but the more folks you have on your nine 90 who are at or above the top end of salary survey ranges, the more likely the IRS will focus on the compensation numbers as potential excess benefit. And in yurman , we are not valuation consultants, but we've seen enough comp consultant reports over the years to understand that it's all in how you ask the questions, or more precisely how you select the comparables. Just remember, you may have to defend that selection on audit. So the questions you might want to ask yourself are, are these other organizations in the peer group of similar size and complexity of structure and range of services? Are the positions you are comparing functionally comparable? Are you weight comparables too heavily toward the for-profit sector? Where is your competition for talent? Does that suggest that , uh, a 50 50 waiting with for-profits is appropriate, or is that too aggressive? It's going to vary from case to case. Couple of tips for , for , uh, folks here. First, as they say in financial circles, cash is king. Note that if you check any box on Schedule J part one, line one A of the nine 90 , it's more likely to draw scrutiny than simply paying higher cash comp for the employee to spend on those items themselves. Uh, making for bad PR and potentially drawing IRS interest, given that paying personal living expenses of insiders can be the basis for a finding of inurement. Second, as those recent property tax cases out of Pennsylvania that Stephanie mentioned, have shown leaning too heavily on financial metrics can be an issue. As Stephanie mentioned, the Pennsylvania Appeals Court denied property tax exemption or hospitals for not meeting the requirement of operating entirely free from any private profit motive. In that regard, the court's analysis of executive comp required consideration of whether the amount of compensation is reasonable and the extent, if any, to which it is based on the financial performance of the institution. To me, the implication of that reasoning is that there are potential compliance benefits in tying a significant portion of incentive compensation to metrics that are closely related to the mission, such as improving access to healthcare services by reducing wait time for appointments and improving population health.
Speaker 3:Jerry , I think that's a great point. I mean, in theory, good financial performance of, of a nonprofit hospital means the organization and its executives have been successful in meeting the needs of the community and covering expenses, being good stewards of the exempt assets and income and, you know, carrying on to provide care for another day. Um, uh, there is in our , um, business of an expression, no margin, no mission. It , you know, we, we have to , uh, be able to cover at least costs to put all the , the, the remaining funds into expanding access, those sorts of things, improving care, as you said, but, but being clear and being explicit that mission matters in compensation and in retaining talent. I think really Jerry is a, is a fabulous idea in, in helping in situations like this , um, where , um, at least , uh, uh, this corp did not buy that the comp was appropriate, even if it was fair market value.
Speaker 2:Exactly. Uh , we are halfway through our list now. Moving on to issue number six, section 49 60 excise taxes. This is another area of low hanging fruit for the IRS and something they can spot with data matching with W twos nine 90 and 47 20 . The excise tax return section 49 60 is a tax on the employer based on the amount of compensation it imposes an excise tax at the corporate rate. Currently 21% on the employer for compensation of covered employees over $1 million and any excess parachute payments covered employees are your top five highest paid employees of the applicable tax exempt organization each year from 2017 forward. Though, if you fall out of the top five in a future year, you are still a covered employee, that status never changes. Uh, one protection strategy to consider to minimize 49 60 tax exposure is to have a single employer for highly compensated employees using single member LLCs. For subsidiaries, the excise tax applies only to the employer and a single member LLC though it is regarded for employment tax purposes, is a disregarded entity for purposes of section 49 60, assuming it hasn't checked the box to be treated as a corporation. Right. So for example, if a holding company has three hospitals with highly paid executives, but all of them are, all of the hospitals are organized as single member LLCs, then there's only one applicable tax exempt organization for purposes of the 49 60 tax and one set of covered employees instead of three. So that's a potential tax on five employees the first year instead of 15 , uh, for excess parachute payments. Something to bear in mind is that a few dollars in comp can make a big tax difference to the employer because the trigger for the excise tax on excess parachute payments or severance payments is three times the base amount, which is the last five years. Average comp staying just under that threshold could save hundreds of dollars, hundreds of thousands of dollars in excise taxes.
Speaker 3:Yes, Jerry , that's a great point. Um, so just two things. Um, folks should remember that once an employee is on the top five, they're on forever, basically, as long as they're employed, even if their comp is later below that threshold. And the HR department should be educated above these rules and, and be involved in that severance planning , um, as you were mentioning. Secondly, on the excise tax , um, comp , uh, as far as what's gonna happen in the future , um, know that apparently there are is some congressional consideration on removing the exception for medical services, which would mean that doctors who are not serving in an administrative role, but a , you know, a highly compensated physician , um, may get pulled into reporting nonetheless, and potentially a possible rate increase from that. Um, uh, corporate tax rate at 21% that Jerry mentioned, Jerry , we're on two
Speaker 2:Issue number ,
Speaker 3:Issue number seven , <laugh>
Speaker 2:Number seven, loans to directors and officers. This is very much a check your state law situation. Some states may prohibit loans to directors and officers in any circumstance. That was the law in Michigan, for example, from 2008 to 2015. Other states allow loans if the board determines it is in the best interest of the corporation, and some states limit loans to particular purposes and may require security. For example, in California, it's limited to three circumstances for public benefit corporations. Uh, one would be a loan related to split dollar life insurance that's secured by either the cash surrender value of the policy or the death benefit, a loan for principal residence secured by a mortgage, or loans that receive approval from the attorney General. Uh, from a federal tax perspective, loans to directors and officers continues to be a hot button issue for the IRS for characterization as a loan to be respected rather than recharacterized as comp and maybe an excess benefit, you need a reasonable expectation of repayment, proper documentation for a loan that's legally enforceable and specific payment terms with a stated rate of interest, which itself , of course, needs to be market value to avoid excess benefit or environment from a below market loan. Uh , Stephanie, do you wanna say something about what you would recommend with loans?
Speaker 3:Yes. Um, really, I guess my personal view is there's no reason to do a loan for a director. Um, I really recommend that , um, in situations where there's consideration of a loan to a director in particular, that the tax professionals get involved early , uh, which means others should be educated to, to raise a hand and a flag , um, those types of proposals early on to determine is, is that really what is best for the organization as well as the individual. Um, it seems to be more reasonable, you know, in the context of officers as part of employment. Jerry mentioned split dollar insurance, you know, principle residence with a mortgage particularly, you know, as part of a recruiting package. That seems to make more sense, but my personal view is that exempt organizations are not banks. They're not in the business of lending money, and it's important to think about the public perception. You know, kind of the front page news test is, is this really necessary and , um, is it really right for the organization?
Speaker 2:Next, we have accountable care organizations and clinically integrated networks or ACOs and cis, which seem to be pretty much everywhere these days in some
Speaker 3:<laugh> .
Speaker 2:Uh , the IRS is still coming into the 21st century kicking and screaming on population health management as a community benefit. So I think we can expect to see that as an emerging issue on audit with the latest tax developments for ACOs, it's clear we still have a ways to go. As a refresher, an A CO is focused on population health improvement of enrollees in plans with which providers already have an arrangement to be paid for patient care services. In its simplest terms, the A CO seeks to improve how care is provided using various metrics similar to the Medicare Shared Savings Program , albeit with adjustments to reflect particular areas where there's room for improvement in care for the patients being served. And of, of course, many ACOs are , uh, MSSP participants, and that may be their only business for , uh, an ACOs participating physicians. The payments they receive are for improving care, and those payments in theory should be no different and no more of a private benefit than voluntary medical staff using hospital facilities to see patients for whom the physicians bill and collect fees, which is a common practice at virtually any community hospital, for example, such access is generally not treated as a private business use of the hospital facilities by the medical staff. Now, the IRS has been very clear since 2011 that participation in the Medicare Shared Savings Program or MSSP furthers the 5 0 1 C3 purposes of lessening the burdens of government. So there's no UBI for the hospital. If the a CO is structured as a limited liability company, and if the a CO is structured as a nonprofit corporation, it can qualify for exemption. The IRS has issued about three dozen favorable determination letters, recognizing MSSP ACOs as Section five one C3 organizations. What has been frustrating for nonprofit hospitals is that the IRS has refused to recognize that either 100% commercial ACOs or hybrid MSSP and commercial ACOs qualify for exemption as either 5 0 1 C3 or 5 0 1 C four organizations. Here, the IRS seems to be stuck in the 1980s viewing the ACOs as contracting vehicles for the benefit of the participating physicians and commercial payers. Now, the triple aims of the MSSP program of better care for individuals, better health for populations and reduced per capita cost are consistent with achieving the three hallmarks of community benefit for hospitals, improving access to care, improving quality of care, and containing the cost of care. Yet the IRS has insisted on limiting exemption in the A CO area to 100% MSSP or Medicaid ACOs in the latest development. The Fifth Circuit issued its decision in the Memorial Hermann Accountable Care Organization case on October 28th, affirming the tax court decision that the hybrid MSSP and commercial a CO did not qualify for 5 0 1 C four status based on alleged private benefit to commercial payers, including by limiting benefits to insured patients who get care from participating physicians with no services to the uninsured. The court also relied on the Loper Bright decision ending deference to agency interpretations and regulations to essentially invalidate the primary purpose test in the IRS's own regulations , uh, which may open the door for the IRS to disregard its own regulations in an end run around the administrative procedures act. I think there are several other defects in the analysis, including downplaying the source of revenues that about 65% of the revenues were from Medicare, not commercial plans , uh, minimizing the need for robust data and ignoring the direct efforts to manage patient care for the purpose of improving population health, thus reducing the costs of care. One of the hallmarks of community benefit , uh, the court did not even analyze the integral part theory of exemption. And in fact, in a footnote, the court downplayed the community benefit provided at the system level, and there was also no mention of the ease of entry for physicians to participate in the A CO or the use of the learnings from the A CO to improve patient care generally , uh, let alone the decades long history of the IRS granting five one C four exemption for arranger model HMOs. Uh, though an HACO is a different animal than an HMO and the Memorial Hermann, a CO itself was not an HMO and did not provide or arrange for health services in a manner common to H HMOs. The analysis is arguably similar, a as of when we are recording this podcast, we don't know if the taxpayer will request a rehearing on bon in that case or whether the Supreme Court would welcome an opportunity to clarify Loper Bright . It also remains to be seen how the IRS will apply this decision in other circuits and to other types of organizations such as HMOs. It is possible the IRS will issue what's called an action on decision to clarify how the decision will be applied in other circumstances and other jurisdictions , uh, depending on how the dust settles on this case. Some helpful facts in the future for ACOs seeking 5 0 1 C3 or 5 0 1 C four determination letters might include adherence to the MSSP principles for determining cost savings and metrics, publicizing the data, reducing barriers to patient participation in the program, a comparison of performance statistics for population health with and without the assistance of an A CO , and demonstrating that they've been applying the learnings from the a CO across the hospital systems patient base, including for charity care patients . And finally, a word about cis. Uh, those that are structured to coordinate care without having a formal relationship with a payer such as an A CO . Uh , here the , the focus is going to be on UBI assuming the clinically integrated network is treated as a partnership for federal tax purposes. We can refer to past IRS guidance on physician hospital organizations, which suggests one would look to the extent to which the patients , uh, two , which the P ho's activities or now the CI's activities are directed are patients of the hospital for federal tax purposes. So the CIN services are arguably sort of a management and consulting service, which if related to care for the hospital's patients should not be UBI.
Speaker 3:Jerry , thank you so much for that summary. Um, especially of the recent Fifth Circuit case. Uh , I just wanna say that it's always exciting , um, for us to have something new and , um, very current to talk about that October 28th case , um, is a , is is a bit of a , um, a surprise, I guess I will say. Um, it's, it's frustrating, you know, it's , it's kind of another one of those exempt organization, catch 22 situ situation . So lowering the cost of care, improving quality, you know, as Jerry mentioned , uh, but for Medicare patients in particular, it doesn't really seem like it should matter if , um, the tax exempt hospital system is doing that ver , you know, vis-a-vis , um, Medicare Advantage plans, which are more and more common , um, um, or through an M-S-S-P-A-C-O. Uh, certainly I , I'm not trying to suggest, nor is Jerry , that the for-profit should not pay its fair share of tax, but it seems like, just like in, in the relatively settled tax analysis for exempt organizations that participate in joint ventures with for-profits , um, the income should be ab able to be evaluated , um, as it would be there in the hands of each partner. But moving on to , uh, top 10 issue number nine, political activities , um, the election season is over, so hopefully all the exempt organizations out there did a good job of watching for unauthorized political activity , um, by their employees or, or others , um, who have access to their facilities. Like sticking political yard signs on hospital , uh, property annual education around election time is, is a, is a really good , um, preventive practice. Um, but just to kind of refresh the prohibition on political activities by a 5 0 1 C3 organization is absolute, there is both an excise tax on political expenditures, and there is an exemption risk. You cannot intervene in a political campaign is the technical lingo through cash or in kind contributions to support or oppose any candidate for any elected public office. Um, there is a revenue ruling 2007 dash 41 that provides some detailed examples of what is and what is not political campaign intervention for your reference. Uh , but just because someone is employed by a C3 doesn't mean that they, you know, also somehow lose their first amendment rights of political expression , uh, as long as they do it on their own time and on their own dime. Um, also important to remember that lobbying is not the same as a political campaign activity and lobbying is okay for 5 0 1 c threes as long as it is not substantial. In relation to the organization's overall activities, it's really also important to scrutinize lobbying activity , uh, particularly during election years on any issue that may be tied to a particular candidate as to how and whether to proceed in that lobbying effort. Uh, it's also important I to scrutinize events , um, that , uh, elected officials , um, will , uh, attend on your campus and an effort to support the local community. Local officials often visit key healthcare facilities , um, but some of those elected officials are always running , um, members of the house, for example. So timing of those visits may matter, and in every case, it's really important to ensure in advance that the staffers understand and your staff understand what the guardrails are. Jerry .
Speaker 2:Uh, historically there's also been a workaround of sorts for 5 0 1 C3 organizations in the political activity area. Uh , the outright prohibition Stephanie mentioned on political campaign activity does not apply to a 5 0 1 C four organization. So a 5 0 1 C3 with a 5 0 1 C four could find itself with a PAC in the C four under the C four . Uh, if the C four is sufficiently separate from the C3 and neither the C four nor the PAC are subsidized by the C3 or a 5 0 1 C3 organization could decide to spin off its governmental affairs or lobbying activity, if you will, into a 5 0 1 C four organization, which would then set up a PAC again, observing separateness from the 5 0 1 C3 and not being subsidized by the C3. The IRS issued a private letter ruling on that structure several years ago, 20 11 2 7 0 1 3 . Uh , we saw in another ruling more recently from the IRS, however, private letter ruling 2 2 0 5 0 2 0 , that sharing staff and other resources between the C3 C four and the PAC could cause the PACS activities to be attributed to the five one C3 , which would be an exemption issue. I would also add that , uh, a recent Wall Street Journal article from October 30th , uh, commented on the Memorial Hermann decision and its implications in the political arena , uh, and , and noted that the decision may call into question the extent to which a 5 0 1 C four organization actually may engage in political campaign activity . In essence, the court in Memorial Hermann, as I mentioned, relied on Loper bright to overturn what's called Chevron deference to agency rulemaking, and use that to invalidate the primary purpose test in the 5 0 1 C four regulations, which is not mentioned in the statute in favor of a stricter exclusive purpose test that the court noted is included in the statute. Uh , political activity has not been viewed historically as a social welfare activity. Uh , however, there is , uh, a little wrinkle in the regulations that , um, may provide some hope going forward for c fours, maybe , uh, a very strong possibility of continuing their activities. Uh , it , it's also worth knowing that , uh, taking a stricter approach to c fours would be at odds with IRS letter 52 28, which essentially provided a 60 40 safe harbor, where up to 40% of the activities, four or five one c four could be political campaign activity. Well, as one commenter noted , uh, the court's decision also could mean that the political activity reference in the five one C four regulations is also in value because that reference is not in the statute. The statutory language does not prohibit any political activity by a five one C four organization. So , uh, political activities that are related to a social welfare activity such as related to furthering a green agenda, that's what the organization is about, may be perfectly permissible for 5 0 1 C four going forward. So it remains to be seen where the IRS is going to come out on this. Uh, in recent years, it's been sort of a, a third rail that , uh, the IRS has not been willing to venture back into. And finally, that brings us to number 10 on our top 10 list offshore investments. <laugh> offshore investments for nonprofit healthcare organizations are typically either captive insurance companies where the investment essentially constitutes reserves for the captive or hedge funds or other investment portfolios that are operated out of an offshore jurisdiction. Either one can catch the attention of the IRS and trigger an audit if the dollars are large, and particularly if they fluctuate year to year . If it's a captive, you have a few potential issues, including the federal excise tax on premiums under Section 43 71, and potentially similar state premium taxes and unrelated business income for coverage provided to physicians and non-controlled entities under Section five 12 B 17. Whether the offshore investment is a captive or a hedge fund, there is a potential for bad optics, particularly if hospital executives or board members are traveling overseas for meetings with luxury accommodations, meals, and entertainment.
Speaker 3:So Jerry , uh, we finished our top 10. How about , uh, time for some compliance strategy and a few con con concluding thoughts, maybe
Speaker 2:<laugh> , uh, good idea, Stephanie. Let's, let's start by reminding folks again of the front page test. It's really twofold. How would it look splashed on the front page of your local paper and who's reading the headlines? And remember, the IRS reads the headlines too, and they are out there auditing . So , uh, Stephanie, you wanna talk about a few protection strategies?
Speaker 3:Sure. So as, as we said, you know, there's increased focus on tax exempt organizations again, and whether nonprofit , tax exempt hospitals in particular are doing enough. So it's kind of what's old is new, again, same concerns as we've heard have heard about in the last 20 years , um, and maybe even more focus , um, in 2025 since the TCJA will be expiring, and it'll be a big year for federal tax legislation. Um, protection strategy is , strategies really are having processes and a structure that promote compliance education, tracking, reviewing, so for example , um, having in-service training on tax considerations, being really deliberate about discussion of mission and operations , um, really making sure you have a process to track conflict of interests. And , um, they're making sure that those who must comply with your COI policy understand that they have an ongoing disclosure obligation. Having really bulletproof executive and physician comp, meaning having, you know, appropriate , uh, review in advance, documenting that. Um, Jerry talked about, you know, your comparables and making sure you have a mix of for-profit and non-profits , um, in that peer group. For example, emphasizing the mission component for incentive comp , um, having appropriate payroll controls and AP controls on , um, things like expense reimbursement, your compensation formulas. Um, it's always a good idea to have a board or a committee , uh, do a pre-filing review of your nine 90. And, you know, also having , um, a board or committee , uh, focus on approving FAP changes, financial assistance, policy changes, and certainly being aware of community health needs assessments, conclusions, and being involved in implementation strategy. Also, certainly having them review significant transactions and compensation packages in advance. How about you, Jerry ?
Speaker 2:Well, I think it's important to emphasize board level actions to promote compliance , uh, to demonstrate you take conflicts seriously, such as by having a standing agenda item for each meeting or disclosure of new conflicts minutes have to be detailed enough to satisfy the rebuttable presumption for compensation arrangements and transactions with potential disqualified persons. And I would suggest treating them like a court filing, like a brief or exhibit A to a complaint, because that's how they may end up if you get audited by the IRS uh , board. Continuing education is important , uh, to , it's important to do that annually on tax topics and to include reports on tax issues under the compliance function. Uh, do an annual review of board policies identified in the form nine 90, part six, lines 10 through 16. Consider doing proactive mock audits for ubit , uh, compensation, five one R community benefits, et cetera , to help identify exposure audits before the IRS comes knocking. And finally, depending on the issue, consider whether to pursue a walk-in closing agreement with the IRS, if you have political activity issues, employment tax problems, or excess benefit inurement or private benefit issues. And , and with that, I would like to thank Stephanie , uh, thank you for joining me today, and thank you to all our listeners for tuning in. We hope you can join us at the next A HLA annual meeting in sunny San Diego on June 30th through July 2nd, 2025. Thank you.
Speaker 3:Thanks, Jerry .
Speaker 1:Thank you for listening. If you enjoy this episode, be sure to subscribe to a HLA speaking of health law wherever you get your podcasts. To learn more about a HLA and the educational resources available to the health law community, visit American health law org .