The Internal Revenue Service has issued its long-awaited final report regarding the results of its 2006 study of nonprofit hospitals (the Report). The study involved distribution of a compliance-check questionnaire to over 500 hospitals across the United States and focused on two broad areas of inquiry: (1) the nature and extent of activities undertaken by hospitals relevant to demonstrating compliance with the “community benefit” test for Section 501(c)(3) exemption,1 and (2) the practices and policies used by hospitals in compensating senior executives. The IRS earlier had issued an interim report that provided preliminary findings regarding community benefit only and was not prepared to address executive compensation at that time, because it was supplementing its review in that area through focused examinations of 20 tax-exempt hospitals and health systems. The Report, posted to the IRS website here (at http://www.irs.gov/charities/charitable/ article/0,,id=203109,00.html), February 12, 2009, now provides extensive details regarding both areas of inquiry.

The Report and its various conclusions are likely to be cited by a range of stakeholders in months to come, including congressional officials, IRS leaders, hospital representatives, watchdog groups, the media, labor unions and others. Oddly enough, the Report contains nuggets that will be useful to all of these stakeholders, notwithstanding the variations in their purposes, perspectives and overall objectives (political, legislative, administrative, economic, strategic or otherwise).

The consensus on the Report is that it validates the need for the extensive – if not intrusive – new Form 990 inquiries about community benefit and executive compensation, and reinforces the widely-noted need for consistent definitions and reporting standards in these areas. The Report’s conclusions confirm the wide variation in challenges and opportunities faced by tax-exempt hospitals, i.e., the sector is not susceptible of simple description or amenable to simple fixes. The Report arguably demonstrates the weakness of proposals that would impose black-and-white “minimum requirements” for hospitals to maintain tax-exempt status.

The Report is also notable for its rather unusual approach on the topic of executive compensation, i.e., including suggestive commentary in addition to its factual findings and conclusions. Specifically, despite conceding that the executive compensation practices of tax-exempt hospitals are generally within the bounds of the law and that most hospitals are following the procedures outlined in Treasury Regulations, the IRS nonetheless suggests that the compensation levels may be considered to be unreasonably high when judged in the court of public opinion.

Analytical Approach

The IRS employed a variety of techniques in distilling the raw data from the questionnaires (and, in the case of executive compensation, its follow-up examinations). The approach included segregating hospitals into demographic categories based on community type and revenue size. The categories for community type, and their respective share of the total hospitals participating in the study, were as follows:

  • High-population hospitals, meaning those in the 26 largest urban areas in the
  • United States (19 percent)
  • Other urban and suburban hospitals (51percent)
  • Critical access hospitals (14 percent)
  • Other rural hospitals (16 percent)

The categories for revenue size were as follows:

  • Over $500 million (7 percent)
  • $250-$500 million (13 percent)
  • $100-$250 million (27 percent)
  • $25-$100 million (36 percent)
  • Under $25 million (17 percent)

The Report also includes comparison data based on per capita income levels of surrounding geographic areas and on the extent to which the local population was uninsured.

Findings—Community Benefit

The Report offers conclusions regarding community benefit expenditures on a broad level, conclusions regarding uncompensated care and observations regarding “excess revenues” of participating hospitals.2 Notably, neither the questionnaire nor the Report used the term “charity care,” presumably due to wide variations in how that term is defined across the sector.

First, regarding community benefit expenditures generally, the Report indicates that, on average, hospitals participating in the study spent 9 percent of total revenues on community benefit expenditures. The community benefit expenditures of rural hospitals (critical access and otherwise) generally were lowest (as a percentage of revenues), while high-population hospitals were highest. In fact, the relative community benefit expenditures of participating hospitals (again, as a percentage of revenues) generally increased with the organizations’ revenue size. The Report observes that community benefit expenditures were not evenly distributed across the participating institutions, with 9 percent of the hospitals reporting 60 percent of the aggregate community benefit expenditures in the study. Among all participants, 47 percent reported total community benefit expenditures of less than 5 percent of total revenues.3 Somewhat surprisingly, the Report indicates that the IRS did not find a correlation between community benefit expenditures and the per capita income levels of the surrounding area. A correlation was found, however, between community benefit expenditures and the extent of the local population that was uninsured.

Second, regarding uncompensated care, the Report indicates that such expenditures on the whole accounted for 56 percent of the overall community benefit expenditures in the study. That number shot up to 71 percent when the IRS removed the data from 15 large research institutions participating in the study (which collectively accounted for 93 percent of the total research expenditures in the study). On average, hospitals devoted 7 percent of their total revenues to uncompensated care; 58 percent of hospitals reported uncompensated care amounts less than or equal to 5 percent of total revenues.4 The Report observes that there appear to be wide variations in uncompensated care expenditures among participants, with 14 percent of the participants reporting 63 percent of the aggregate uncompensated care expenditures in the study.

After uncompensated care, the other major categories of community benefit expenditures were medical education and training (comprising 23 percent of aggregate community benefit expenditures in the study), research (15 percent) and community programs (6 percent).

Third, regarding overall financial performance, participating hospitals averaged “excess revenues” (i.e., total revenues minus total expenses) of 5 percent of total revenues. The Report indicates that here, too, participants showed substantial variations, with the largest hospitals (by revenue) generally being the most profitable, and critical access hospitals and smaller hospitals the least. Among the participants, 79 percent of the participating hospitals had positive excess revenues, with 21 percent reporting deficits. Given that much of this data is now nearly four years old, and considering the dramatic downturn in the national economy, one might speculate that this figure would be considerably lower today.

Findings—Executive Compensation

The 2006 questionnaire honed in on whether tax-exempt hospitals were complying with the procedures to achieve a rebuttable presumption of reasonableness under Internal Revenue Code Section 4958 and corresponding regulations.5 Nearly all surveyed hospitals reported having complied with the rebuttable presumption procedure, thereby establishing a presumption of reasonableness and placing the burden on the IRS to prove that compensation exceeded reasonable, fair market levels.

The questionnaire also solicited details regarding salary and other compensation (including employee benefit plans and deferred compensation plans) paid to hospital officers, directors, trustees and key employees. The Report concludes that, in general, the amount of compensation increased with revenue size. In addition, compensation was lower for rural hospitals than for urban and suburban hospitals, with critical access hospitals reporting the lowest compensation, and high-population hospitals the highest. The average and median salaries paid to the top management official (CEO) at surveyed hospitals were $490,000 and $377,000, respectively. In part two of the study, 20 hospitals were selected for IRS examination based on compensation amounts that appeared relatively high, after taking into consideration the size and other circumstances of the hospital. (The average and median compensation amounts paid to the top management official at these selected hospitals were $1.4 million and $1.3 million, respectively.) The IRS examined whether these compensation amounts should be challenged under Section 4958. Even among these higher-paying hospitals, however, the compensation amounts were generally upheld as established pursuant to the rebuttable presumption process and found to be reasonable, market-based compensation. All 20 hospitals had a written conflict of interest policy to which they adhered and 85 percent of them (compared to 73 percent of hospitals in the general compliance check) had a written compensation policy.

What Lies Ahead

In the months ahead, the IRS likely will devote considerable effort to public discussion and commentary regarding the study and the Report.

While IRS representatives have consistently indicated that the community benefit standard is still the law (at least for now), the IRS continues to feel pressure from Capitol Hill for greater enforcement. In connection with the recent economic stimulus legislation, Sens. Chuck Grassley (R-Iowa) and Jeff Bingaman (D-N.M.) sought unsuccessfully to include amendments that would have required the IRS and MedPAC to establish uniform definitions of the terms “uncompensated care” and “charity care.” Their proposals also would have required the IRS to undertake a new study addressing the differences in operation between tax-exempt hospitals and for-profit hospitals (including the amount of uncompensated care, patient services and other benefits provided, as well as executive compensation). Since their amendments did not survive in the stimulus legislation, the tax-exempt hospital sector might expect that Sen. Grassley will continue his scrutiny and, as suggested in the press last December, may propose legislation establishing minimum charity care requirements for tax-exempt hospitals.

As to executive compensation, the Report concludes that nonprofit hospitals generally are not engaging in excess benefit transactions but rather are paying compensation within legal limits. Nonetheless, the IRS has declared its intent to maintain vigilance over these matters through examinations and compliance initiatives. It is a virtual certainty that Sen. Grassley and others will seize upon the IRS’s observations that compensation levels may be unreasonably high (although consistent with current law), particularly in light of executive compensation limitations recently imposed by the Obama administration in the context of financial institutions receiving federal bailout funds. Finally, the rebuttable presumption process likely will continue to face considerable scrutiny, given the Report’s suggestion that its use may be driving compensation to higher levels, with its taxpayer protections unfairly tilting the scales against the IRS in the enforcement setting.