The Pension Protection Act of 2006 (the “Act”), enacted in August 2006, addressed a broad array of topics, including provisions aimed at addressing perceived abuses associated with certain Section 501(c)(3) organizations. Those organizations, known as “supporting organizations,” are classifi ed as public charities under Section 509(a)(3), based on their essential purpose and function of supporting other charitable organizations. In the healthcare context, most health systems having a “parent” entity will fi nd that it is classifi ed as a Section 509(a)(3) supporting organization based on its role in providing administrative and support services to one or more hospitals or other operating subsidiaries. Similarly, many hospital foundations also are classifi ed as Section 509(a)(3) organizations. As a result of the Act, supporting organizations such as hospital parent corporations and hospital foundations now are restricted in their dealings with substantial contributors, and effectively banned from making loans to offi cers, directors and other disqualifi ed persons.

This client alert is not intended to provide an exhaustive description of the Act’s provisions relating to Section 509(a)(3) organizations. The Act has imposed new restrictions on Section 509(a)(3) entities that are suffi ciently onerous to prompt many supporting organizations to seek reclassifi cation under an alternative public charity status if available. Recognizing this concern, the IRS has established an expedited process by which Section 509(a)(3) organizations may seek reclassifi cation.

Currently, DBGC is assisting several hospital foundations in using this process to achieve reclassifi cation from a Section 509(a)(3) supporting organization to status as a “publicly supported” organization under Section 509(a)(1).

While reclassifi cation may be an attractive option for hospital foundations, most health system parent entities will not qualify for any public charity classifi cation other than Section 509(a)(3), leaving them to deal with the Act’s new restrictions. Among the Act’s more troubling provisions, Section 1242 of the Act expanded the coverage of Code Section 4958. That section, enacted in 1996, imposes penalty excise taxes (known as “intermediate sanctions”) in cases where tax-exempt organizations engage in transactions or arrangements with persons holding substantial infl uence over such organizations (known as “disqualifi ed persons”) on terms that are other than fair market value or other than reasonable compensation (known as “excess benefi t transactions”). The IRS has determined that such excise taxes also apply in situations where exempt organizations make certain types of compensatory payments (cash or noncash) to disqualifi ed persons but fail to report such payments appropriately for tax purposes.

Now, the Act has added a whole new type of excess benefi t transaction involving only Section 509(a)(3) supporting organizations. Specifi cally, new Code Section 4958(c)(3)(A) provides that an excess benefi t transaction will be deemed to exist any time that a Section 509(a)(3) supporting organization undertakes either of two types of arrangements.

First, a supporting organization will be considered to have undertaken an excess benefi t transaction if it makes a grant, loan, compensation, or other similar payment to a “substantial contributor,” or to a family member or 35-percent controlled entity of a substantial contributor. For these purposes, the term “substantial contributor” means someone who has contributed or bequeathed a total of more than $5,000 to the organization, if such amount is more than 2% of the total contributions and bequests received by the organization before the close of the current taxable year. In the context of health systems, this new provision means that caution should be taken whenever executives or other employees (i.e., persons who are compensated by the organization) make charitable contributions to health system entities, and particularly to health system parents (which typically do not receive substantial contributions from the public).

Second, and likely of broader effect on healthcare systems, a supporting organization will be deemed to have engaged in an automatic excess benefi t transaction if it makes any loan to a “disqualifi ed person” (other than another charitable organization described in Section 509(a)(1), (2) or (4)). For these purposes, the term “disqualifi ed person” includes any person who either currently is, or within the past fi ve years was, in a position to exercise substantial infl uence over the organization, or a family member or 35-percent controlled entity of a disqualifi ed person. The foregoing provisions may be implicated, for example, if:

  • A health care system parent entity enters into any form of loan arrangement with a top executive;
  • A hospital foundation makes an interim loan to the health system parent entity; or
  • A health system parent entity, as part of an employee educational assistance program, makes a loan to an employee whose grandparent serves on the organization’s board of directors.

None of the foregoing arrangements would appear on its face to be unreasonable or otherwise improper, particularly if it provides for market-rate interest and terms of payment. However, as a result of the Act, each of the foregoing arrangements would subject: (i) the borrowers to penalty taxes on the full amount borrowed at rates of 25% and, if not timely corrected, another 200%; and (ii) the leadership (in this context, known as “organizational managers”) of the lending 509(a)(3) organization to penalty taxes on the full amount borrowed at rates of 10%, up to a maximum of $20,000 per arrangement. Such a result could come as a great surprise to healthcare organizations, which historically have understood applicable tax laws to require merely that loans be structured with market terms or, if the circumstances warrant, even below-market rates. While the new rules may help combat genuine abuses involving other types of 509(a)(3) organizations, in the tax-exempt healthcare sector, they arguably have little merit.

Transitional rules may shield arrangements that were implemented prior to July 25, 2006. For arrangements implemented since then, however, and for any new arrangements being considered involving Section 509(a)(3) health system parent entities or fundraising foundations, the new rules apply. In certain cases, penalty taxes may be avoided by causing proposed arrangements to be undertaken by affi liated hospitals or other operating entities that are not themselves described in Section 509(a)(3). Alternatively, some arrangements may benefi t from the so-called “initial contract exception” under existing intermediate sanctions regulations, which would have the effect of causing certain newly-recruited executives to be treated as other than “disqualifi ed persons” in connection with the negotiation of their initial terms of employment.