URMC Compliance Program Policy Manual:
Tax-Exempt Organizations: Maintaining Tax-Exempt Status
As non-profit providers serving charitable purposes, the URMC entities hold Federal tax-exempt status under section 501(c)(3) of the Internal Revenue Code. In order to qualify for that exemption, and to be eligible to receive tax-deductible contributions, an organization must be operated exclusively for charitable purposes - a standard which is generally met by operating an emergency department open to all, providing care to all who can pay, offering medical staff privileges to all qualified physicians, complying with anti-dumping and fraud and abuse laws, and maintaining a governing body comprised primarily of community members rather than organization insiders. The organization's exempt status may be revoked if it permits any private inurement of its assets to organization insiders or allows individuals to enjoy more than an insubstantial private benefit from the organization's activities. Even if exempt status is retained, the organization may be subject to "intermediate sanctions" penalty taxes if it enters into transactions that excessively benefit private individuals. In addition, the organization will be subject to tax (at corporate rates) on any income it receives from trade or business activities unrelated to its charitable purpose.
A section (501)(c)(3) organization is prohibited from engaging in activities that result in "inurement" of its asserts or earnings to insiders - that is, individuals whose special relationship offers them an opportunity to benefit economically from the exempt entity's income or assets. In the context of health care organizations, the IRS has broadly interpreted the term "insiders" to include not only founders, directors, and officers, but also physicians. If private inurement occurs, the IRS may revoke the organization's tax-exempt status.
Physician compensation often raises private inurement concerns, particularly in the context of revenue-sharing arrangements. An agreement to pay a specialist a fixed percentage of a department's gross income, for instance, may create private inurement. The entity's Chief Financial Officer, with the aid of counsel if desired, should review all such compensation arrangements to ensure that the total compensation paid is reasonable, that the recipient has no control over the organization, and that the arrangement is negotiated at arm's length. The CFO should also review other forms of incentive compensation for reasonableness, particularly if bonus payments are not capped and are based primarily on financial targets rather than patient satisfaction or the quality of care provided. Other potential sources of private inurement, which should be brought to the attention of the CFO and counsel if the arrangement is not negotiated at arm's length, include:
- Sales, exchanges, or leases of property between the entity and a private individual
- Loans or other extensions of credit between the entity and a private individual
- Contracts for goods, services, or facilities between entity and a private individual
- Payment or reimbursement of a private individual's expenses
- Partnerships or joint ventures between the entity and physician groups
In contrast to the prohibition against private inurement, which only applies to organization insiders, the private benefit restriction applies to all individuals, regardless of their relationship to the organization. The private benefit limit requires the tax-exempt entity to serve public rather than private interests. Unlike the absolute prohibition on private inurement, however, incidental private benefit will not jeopardize an organization's exempt status. Senior Administrators and Directors should review contracts with commercial providers of goods or services, compensation packages of non-insiders, and joint ventures or partnerships with non-organization personnel or entities to ensure that the arrangements are reasonable and primarily benefit the entity's charitable functions rather than private interests.
Many situations that raise concerns about private inurement or private benefit are also likely to create a tax liability under the "intermediate sanctions" rules. Intermediate sanctions allows the IRS to assess penalty taxes when certain individuals or entities, referred to as "disqualified persons," receive "excess benefits" from an exempt organization such as the University of Rochester. A "disqualified person" is defined as any person or entity that is in a position to exercise substantial influence over an organization. The organization's officers, directors, and trustees, as well as substantial donors and the five highest-paid employees, are likely to be considered disqualified persons. Physicians, although generally considered "insiders" for purposes of the private inurement prohibition, will only be "disqualified persons" subject to intermediate sanctions if they in fact possess substantial influence over the organization.
Intermediate sanctions will be imposed if a disqualified person receives an excess benefit from the tax-exempt entity—in other words, if the organization provides an economic benefit whose value exceeds that of any consideration (including the performance of services) received in return. Likely sources of excess benefits are compensation packages (including fringe benefits and deferred compensation); sales, leases, or exchanges of organization property and assets; and joint ventures or partnerships with private individuals or entities. If an excess benefit transaction occurs, the disqualified person will be subject to an excise tax equal to 25% of the excess benefit received, and to an additional 200% tax if the benefit is not repaid or otherwise corrected within a given time after receiving notice from the IRS. In addition, any organization "manager" (officer, director, trustee, or person with similar responsibilities) who knowingly and willingly allowed the entity to provide the excess benefit will be subject to a 10% tax, capped at $10,000.
To create a presumption that a given arrangement will not create an excess benefit, the compensation packages of disqualified persons, as well as any other potential excess benefit transactions, must be approved pursuant to the intermediate sanctions safe-harbor procedure. Specifically, the arrangement should be approved by the organization's Board (or a board committee); any board members with a conflict of interest regarding the transaction under consideration should excuse themselves. In evaluating the arrangement, the board (or committee) should review specific data from comparable transactions. Relevant data for a compensation package, for example, would include compensation levels (including all fringe benefits and deferred compensation) paid by similar health care organizations (both for-profit and tax-exempt) for functionally comparable positions; the organization's location and the availability of similar specialties in the geographic area; independent compensation surveys by nationally recognized independent firms; and written offers from similar hospitals or facilities competing for the disqualified person's services. The board or committee must also document the basis for its decision to enter into the transaction; minutes should include a description of any conflicts of interest, the comparable data that was reviewed, and the basis for concluding that the disqualified person would not receive an excess benefit.
Physician Recruitment and Practice Acquisitions
The IRS closely scrutinizes incentives provided by tax-exempt providers to newly recruited physicians. Incentives such as a signing bonus, payment of malpractice premiums, below-market rental of office space, or income guarantee may be attacked by the IRS if those amounts, when added to the physician's actual salary and benefits package, result in a total compensation package that is unreasonable. Unreasonable compensation, if provided to a physician with substantial influence over an organization (e.g., the chief medical officer) may subject the physician and organization managers to intermediate sanctions penalties. In an extreme case, the IRS may revoke the entity's tax exemption on private inurement or private benefit grounds. To avoid incurring penalty taxes or risking the loss of the tax exemption, recruitment packages offered to physicians expected to possess substantial influence over the particular tax-exempt organization, or to physicians expected to be among the organization's highest paid employees, must be approved by a disinterested board or committee, with careful attention paid to data from comparable arrangements, and adequately documented to demonstrate the reasonableness of the total compensation package.
From a tax standpoint, physician practice acquisitions raise issues similar to those in physician recruitment. If the tax-exempt entity pays more than fair market value for the practice, the IRS may impose penalty taxes under intermediate sanctions on the physicians, if they possess substantial influence over the entity, and on managers who approve the transaction. Whether or not penalty taxes are imposed, the IRS may revoke the entity's tax exemption if the overpayment constitutes private inurement or private benefit. To guard against penalty taxes or loss of exemption, practice acquisitions should be reviewed by the entity's board (or a board committee) in accordance with the safe harbor procedure discussed above.
Unrelated Business Taxable Income ("UBTI")
A section 501(c)(3) organization will generally be exempt from federal income tax. The organization will be taxed at regular corporate rates, however, on income that it receives from an unrelated trade or business ("UBTI") that it regularly carries on. Investment income or gains generally will not constitute UBTI unless those proceeds are debt-financed or are received from a controlled corporation. UBTI may be offset by deductions for costs—such as rent or labor—that are connected with the UBTI.
A UTB in any activity that is performed by the tax-exempt organization and does not substantially relate to its exempt purpose. An activity will be substantially related if it contributes importantly or is causally related to the organization's exempt purpose, but will not be so related if conducted on a scale larger than reasonably necessary to perform functions in furtherance of that purpose. A UTB does not include any trade or business in which substantially all the work is performed without compensation or which is carried on primarily for the convenience of the organization's patients, employees, or officers. The following businesses, although often exempt from tax under that "convenience" exception, tend to attract IRS scrutiny and should be reviewed to determine whether UBTI is being generated.
- Laboratory services
- Pharmacy sales
- Leasing of medical buildings
- Parking facilities
- Laundry services
- Cafeterias, coffee shops, and gift shops
Income from medical research is also an occasional source of UBTI. Basic research—that is, research without an application-oriented testing component—generally will not give rise to UBTI, even if the research is privately sponsored. Likewise, research in which the drug or device being tested is used therapeutically is unlikely to create UBTI, as is research that serves to educate medical students or personnel. UBTI may result, however, from research incident to commercial operations, such as the ordinary testing or inspection of materials or products that benefit private rather than public interests. Thus, the more the entity's activities resemble routine testing (in particular, testing that could be done commercially), the more likely UBTI will be generated. Sponsored research contracts should be reviewed to determine whether any of the arrangements give rise to UBTI.
The Internal Revenue Code imposes strict limits on "private business use" of tax-exempt bond proceeds. Private business use, generally speaking, is the use of Bond proceeds or a Bond-financed facility by a person in a trade or business; the use of such proceeds or facilities by a section 501(c)(3) tax-exempt organization in furtherance of its exempt purposes does not constitute private business use. Examples of private business use include:
- Leasing all or a part of a bond-financed facility to a for-profit endeavor, such as private physician offices, gift shops, or other concessions
- Entering into contracts with service providers -- management organizations, physicians, cafeterias, janitors, vending machine companies, and the like -- that do not satisfy management contract safe harbors or do not constitute incidental use under the private use regulations.
- Operating parking garages that are not available to the general public on a first-come first-served basis or for patients or employees of the organization
- Loaning Bond proceeds to for-profit person or endeavor
- Constructing facilities to be used as private physician offices
- Engaging in activities that give rise to UBTI
- Entering into research agreements with private companies
- Selling bond-financed property in violation of the change-in-use restrictions for each issuance of Bonds, private business use may be supported by up to 5% of the Bond proceeds, minus the percentage of issuance costs (usually 2%) financed with Bond proceeds. In effect, then, generally no more than 3% of Bond proceeds may support private business use. If Bond proceeds are spent directly on private business use, the percentage should be based on the actual dollars expended; if the private business use related to a Bond financed facility, the percentage should be measured in terms of square footage or output (e.g., number of hours). If the amount of private business use exceeds 3%, the Compliance Officer and counsel should determine whether that percentage can be reduced on account of payments received from the private user.
Political Campaigns and Lobbying Activities
The Internal Revenue Code prevents a tax-exempt organization, or any of its representatives acting in an official capacity, from participating or intervening in any political campaign on behalf of, or in opposition to, any candidate for public office. The organization is also prohibited from carrying on more than an insubstantial amount of lobbying, propaganda activities, or other attempts to influence legislation.
A tax-exempt entity is required to provide written disclosure to any donor who retains an interest in contributed property (e.g., a charitable gift annuity, lead trust, remainder trust, or pooled income fund) that may be commingled with other tax-exempt assets in a collective investment vehicle. Similarly, the organization must provide disclosures to donors who have made quid pro quo contributions—that is contributions for which the donor has received something of value in return. The IRS may impose penalties in the amount of $10 for each quid pro quo contribution (up to $5,000 per fund-raising event) for which adequate disclosure is not provided.