Tax-exempt status of hospitals under the microscope

Tax-exempt status of hospitals under the microscope

As federal, state, and local deficits continue to climb, large entities that enjoy significant tax breaks are subject to increased scrutiny.  Hospitals throughout the country are in the spotlight as they benefit from billions of dollars of tax exemptions per year.

To qualify as a federally tax-exempt charitable organization under section 501(c)(3) of the Internal Revenue Code, a hospital must demonstrate that it provides a community benefit.  To qualify for state sales and use, income and property tax exemption, most state governments examine whether a hospital provides some form of charity care.  The type and definition of charity care or community benefit differs from state to state (e.g., the Commonwealth of Pennsylvania statute refers to ‘uncompensated goods and services’).  The community benefit standard includes a variety of factors, but does not generally specify how much a hospital should spend on charity care or community benefit to qualify under either federal or state statutes.  Naturally, hospitals argue less, governments argue more, and these differences of opinion often end up in court.

Hospitals are losing tax-exempt status

A recent New Jersey Tax Court case from 2015 illustrates this new reality that hospitals face.  Issued by Judge Vito Bianco, the ruling essentially held that Morristown Medical Center, a New Jersey not-for-profit hospital organization, was functioning as a for-profit entity, and therefore was not exempt from New Jersey property tax.i  The judge stated: “If it is true that all non-profit hospitals operate like the hospital in this case . . . then for purposes of the property tax exemption, modern non-profit hospitals are essentially legal fictions.”  Judge Bianco found that the hospital “operated and used the property for a profit-making purpose” by, in part, providing substantial loans, capital, and subsidies to for-profit entities, including physician groups.

Some of these practices are not uncommon for tax-exempt hospitals.  In the New Jersey case, the judge interestingly focused more on the hospital’s operations than its benefit to the community.  This analysis is different from the approach taken in other cases, which typically focuses more on community benefit. 

Another reason cited for the holding was the process for determining fair market value executive compensation.  The judge did not accept the hospital’s argument that its executive compensation was reasonable by comparing compensation levels with those of similar organizations (per IRS guidelines) because the hospital failed to verify that the compensation at those similar institutions was also reasonable.  It is difficult to imagine how the courts and taxing jurisdictions can require that a charitable hospital seek comparables and also expect them to ‘audit’ the compensation paid by comparable organizations. 

The decision’s impact is making waves throughout the Garden State, as city officials are calling for assessing property taxes on other tax-exempt hospitals.  In lieu of pursuing an appeal, Morristown Medical Center agreed to pay ten years of back taxes and penalties on portions of the hospital used for certain for-profit activities.ii  The agreement may be too complicated to apply to all hospitals and may not necessarily offer a simple statewide solution.

While somewhat alarming, these types of decisions are not new to the industry.  Back in 2010, the Illinois Supreme Court upheld the denial of a property tax exemption for Provena Covenant Medical Center.iii  In that case, the court found that the hospital failed to generate most of its money from charity, did not demonstrate it “dispensed charity to all who needed it and applied for it,” and did not meet its burden of showing that the hospital is used exclusively for charitable purposes.

Legislative developments

State legislators in New Jersey are discussing a possible bill to establish statewide rules for not-for-profit hospitals to make some type of payment in lieu of property taxes, but the bill would not necessarily require property tax payments for all hospital real estate and buildings.

Illinois is well ahead of New Jersey in this arena with a law passed in 2012 in response to Provena that created a property tax exemption for hospitals.  The law established a test to determine eligibility for property tax exemption based on whether the total value of a hospital’s charitable services or activities is at least equal to the hospital’s estimated property tax liability.

The Illinois law has since survived constitutionality challenges in the lower courts.  Litigation is still pending on the law, however.  These developments bear watching as other jurisdictions look to craft property tax exemption standards for hospitals.

Ripple effects

Not only are hospitals facing tax-exempt scrutiny by governments, but so are health insurance companies.  The California Franchise Tax Board recently revoked the tax-exempt status of Blue Shield of California, subjecting the company—with $13.6 billion of 2014 revenue—to state income taxes.

California tax officials based the decision, in part, on the company’s $4 billion surplus and for failing to offer more affordable coverage or public benefits.  The state took the position that the insurance company did not advance social welfare, which is key for its tax-exempt status.

PILOT programs

One alternative to a legislative fix is a Payment In Lieu Of Taxes, also known as a PILOT program.  In this context a PILOT program often involves agreements between municipalities and hospitals.  This type of program can prevent litigation and does not necessarily require legislation.  These agreements, however, are less regulated and more susceptible to abuse.

Going forward

The door has opened for governments to pursue tax revenue from hospitals and related entities.  There are various approaches to the issue that all potentially impacted parties must consider, such as simple and fair legislative standards, PILOT programs, or litigation if necessary.

Hospitals and entities alike, when conducting financial affairs, must be mindful of the items most subject to scrutiny in an effort to avoid costly and unexpected tax bills in the future.  To that end, hospital organizations and other charities should examine their charity care or community benefit inventory in relation to federal and state guidance to maintain solid footing for their various tax exemptions.  Baker Tilly has a robust understanding of the critical issues and developments and we have assisted charitable hospitals in conducting community benefit risk assessments.

For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.

i AHS Hosp. Corp. v. Town of Morristown, 28 N.J. Tax 456 (T.C. 2015).

ii See Andrew Kitchenman, Morristown Medical Center Tax Ruling Ripples Through Garden State, NJ Spotlight, Nov. 17, 2015, http://www.njspotlight.com/stories/15/11/16/morristown-medical-center-tax-ruling-ripples-through-garden-state/.

iii Provena Covenant Med. Ctr. v. Dep’t of Revenue, 925 N.E.2d 1131 (Ill. 2010).