Nonprofit Healthcare Organizations: Federal Income Tax Issues (Portfolio 486)

Part of Tax

Tax Management Portfolio, Nonprofit Healthcare Organizations: Federal Income Tax Issues, No. 486-1st, describes the federal income tax treatment of healthcare organizations that are exempt from tax under §501(a) of the Internal Revenue Code.

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Tax Management Portfolio, Nonprofit Healthcare Organizations: Federal Income Tax Issues, No. 486-1st, describes the federal income tax treatment of healthcare organizations that are exempt from tax under §501(a) of the Internal Revenue Code. Since many nonprofit healthcare organizations qualify for exemption under §501(c)(3), the Portfolio begins with a discussion of how a healthcare organization may qualify as a charity, emphasizing the evolution of the current requirement that the organization be organized and operated for the promotion of health. The Portfolio describes the types of healthcare organizations that may qualify under §501(c)(3) and tells how they may achieve public charity status, either as a per se public organization, a publicly supported organization, or a supporting organization.
The Portfolio also details the federal anti-kickback and anti-referral statutes, with which healthcare organizations must comply to maintain their tax-exempt status. The Portfolio discusses this important body of nontax law which has significant tax implications for all healthcare organizations participating in the Medicare and Medicaid programs.
The Portfolio analyzes a number of other issues that have become significant in the healthcare field in recent years. These include transactions with hospital staff physicians; deferred compensation and profit-sharing arrangements with physicians and staff; healthcare partnerships and joint ventures; the status of managed care organizations, including health maintenance organizations; integrated delivery systems and the purchase of physician practices; the unrelated business income tax; the creation and use of for-profit subsidiaries; tax-exempt financing; employment tax issues; IRS healthcare audits; tax and reporting requirements related to fund-raising; and general compliance, filing, and disclosure issues.
The Worksheets contain selected IRS publications and determination letters related to current tax issues in the healthcare area. They also include the relevant Medicare and Medicaid statutes.
Some issues relating to tax-exempt organizations are covered in greater detail in other Portfolios, to which reference has been made where appropriate. For additional relevant Tax Management Portfolios, check the Estates, Gifts and Trusts “Portfolio Classification Guide.”
This Portfolio may be cited as Washlick, 486-1st T.M., Nonprofit Healthcare Organizations: Federal Income Tax Issues.


John R. Washlick, Esq., CPA

John R. Washlick, B.S. University of Rhode Island (1978); J.D. Southwestern University School of Law (1986); LL.M. (Taxation) Georgetown University Law Center (1990); Adjunct Professor of Law, Widener University School of Law – Health Law Institute, Wilmington, Delaware; Adjunct Professor of Law, Villanova University School of Law (LL.M. in Taxation Program), Villanova, Pennsylvania; member, Pennsylvania and New Jersey Bar Associations; American Bar Association, Section of Taxation; member, American Health Lawyers Association and Health Care Compliance Association; Certified Public Accountant (Pennsylvania); and contributor to various tax publications on issues affecting nonprofit healthcare organizations.

Table of Contents

Detailed Analysis

I. Introduction

II. Qualification for Tax-Exempt Status Under § 501(c)(3)

A. The Statute

B. Hospitals as "Charitable" Organizations

1. Promotion of Health

2. The Financial Ability Standard: 1956-1969

3. The Community Benefit Standard: 1969-Present

a. Amended Regulations Defining "Charitable"

b. Rev. Rul. 69-545

4. Modification to the Emergency Room Requirement

5. Current IRS Position

a. Community Benefit

b. Charity Care

c. Anti-Dumping

d. Compliance with Medicare Anti-Kickback Statute

C. Derivative Exemption - The "Integral Part Doctrine"

1. Structural Relatedness

2. Causal Connection

3. Unrelated Trade or Business Activities

4. The Geisinger Cases

5. IHC Health Plans, Inc.

6. Joint Operating Arrangements and Affiliations

7. Applicability of the Integral Part Doctrine

D. Cooperative Hospital Service Organizations

1. Organizational and Operational Requirements

a. Ownership

b. Allocation of Net Earnings

c. Permitted Income

2. Enumerated Services

3. Eligible Service Recipients - Patron Hospitals

E. Other Tax-Exempt Healthcare Organizations

1. Homes for the Aged

2. Medical Research Organizations

3. Medical Staff of Hospital

4. Medical School Faculty Group Practice Organization

5. Clinics

6. Medical Societies and Professional Boards

7. Group Living Program

8. Home Health Agency

9. Rural Health Center

10. Medical Information Retrieval System

11. State Health Insurance Pools

III. Public Charity Status

A. Private Foundations v. Public Charity Status: Background

B. Public Charity Status

1. Public Charities - § 509(a)(1) Organizations

a. Hospitals

b. Medical Research Organizations

2. Publicly Supported Organizations

a. Publicly Supported Organizations - § 170(b)(1)(A)(vi)

(1) "Substantial Part"

(2) "Normally"

(3) Facts and Circumstances Test

(4) Support

(5) Unusual Grants

b. Publicly Supported Organizations - § 509(a)(2)

(1) One-Third Support Test

(a) Permitted Sources of Support

(b) Limitation on Gross Receipts

(i) Gifts and Contributions Distinguished from Gross Receipts

(ii) Grants Distinguished from Gross Receipts

(iii) Membership Fees

(iv) Grants from Public Charities

(v) Attribution

(2) "Not-More-Than-One-Third Support" Test; Gross Investment Income Limitation

(3) Unusual Grants

c. Rules Applicable to Both Types of Publicly Supported Organizations

(1) Advance Rulings

(2) Reliance by Grantors and Contributors

3. Supporting Organizations - § 509(a)(3)

a. Organizational Test

b. Operational Test

c. Relationship Tests

(1) "Operated, Supervised, or Controlled By"

(2) "Supervised or Controlled in Connection With"

(3) "Operated in Connection With"

(a) Responsiveness Test

(b) Integral Part Test

d. Special Problems Involving Exempt Healthcare Organizations

(1) Parent Holding Company

(a) "Supervised or Controlled in Connection with"

(b) "Operated in Connection With"

(2) Supporting Publicly Supported Organizations Through a Supporting Organization

(3) Parent Holding Company and For-Profit Subsidiaries

(4) "Superparent" or "Grandparent" Structures

IV. Federal Anti-Referral and Anti-Kickback Statutes

A. Background

1. General

2. Distinction Between the Anti-Referral Statute and the Anti-Kickback Statute

B. Enforcement and Jurisdiction

C. Illegal Remuneration

1. Anti-Kickback Statute

2. Exceptions

3. Safe Harbor Final Regulations

a. Final Safe Harbors

(1) Investment Interests Safe Harbors

(a) Large Investment Interests

(b) Small Investment Interests

(c) Investment in Medically Underserved Areas (MUA)

(d) Investment Interests in Solo or Group Practices Composed Exclusively of Active Investors

(2) Space Rental

(3) Equipment Rental

(4) Personal Services

(5) Sale of Practice

(6) Referral Services

(7) Warranties

(8) Discounts

(9) Employees

(10) Group Purchasing Organizations

(11) Waiver of Beneficiary Coinsurance and Deductible Amounts

(12) Practitioner Recruitment in Underserved Areas

(13) Obstetrical Malpractice Insurance Subsidies in Underserved Areas

(14) Cooperative Hospital Service Organizations

(15) Investment Interests in Ambulatory Surgical Centers

(16) Referral Agreements for Specialty Services

(17) Ambulance Replenishing

b. Managed Care Safe Harbors

(1) Waiver of Beneficiary Coinsurance and Deductible Amounts

(2) Increased Coverage, Reduced Cost-Sharing Amounts, or Reduced Premium Amounts Offered by Health Plans

(3) Price Reductions Offered to Health Plans

c. Multiple Purposes

4. Special Fraud Alerts

5. Medicare Fraud Alerts

6. Special Advisory Bulletins

7. Compliance Program Guidance

D. Anti-Referral Statutes

1. Stark I

2. Stark II

a. Self-Referral Prohibition

(1) Designated Health Services

(2) Referrals

(3) Financial Relationships

(4) "Set in Advance"

(5) "Volume or Value" Standards

b. Exceptions to Ownership and Compensation Arrangements

(1) Physician Services

(2) In-Office Ancillary Services

(a) "Same" or "Central" Building Location

(b) Billing

(c) Group Practice

(3) Prepaid Plans

(4) Academic Medical Centers

(5) Other Exceptions

(6) General Exceptions to Ownership or Investment Interests

(a) Ownership In Publicly Traded Securities and Mutual Funds

(b) Hospitals in Puerto Rico

(c) Rural Provider

(d) Hospital Ownership

(7) Exceptions Relating to Other Compensation Arrangements

(a) Rental of Office Space and Equipment

(b) Bona Fide Employment Relationships

(c) Personal Service Arrangements

(d) Remuneration Unrelated to the Provision of Designated Health Services

(e) Physician Recruitment

(f) Isolated Transactions

(g) Group Practice Arrangements with a Hospital

(h) Payments by a Physician for Items and Services

(i) Non-Monetary Compensation Up to $300

(j) Fair Market Value Exception

(k) Medical Staff Incidental Benefits

(l) Risk Sharing Arrangements

(m) Compliance Training

(n) Indirect Compensation

(o) Charitable Donations by Physicians

(p) Professional Courtesy

(q) Physician Retention Programs

(r) Intra-Family Referrals

(s) Temporary Lapses in Compliance

c. Reporting Rules

d. Sanctions

V. Transactions with Hospital-Based Physicians

A. Fundamental Issues

1. Private Inurement

a. Net Earnings

b. Insider Relationships

2. Private Benefit

a. Concept of "Exclusively"

b. Incidental Benefit

c. The Distinction Between Private Inurement and Private Benefit

d. IRS Guidance

e. Reasonableness and Community Need

(1) Reasonableness

(2) Community Need

3. Intermediate Sanctions

a. Legislative and Regulatory Background

b. Disqualified Persons

(1) Disqualified Persons by Reasons of Position

(2) Disqualified Person by Reason of Facts and Circumstances

(3) Other Categories of Disqualified Persons

(4) Persons Who Are Deemed Not Disqualified Persons

(a) By Reason of Position

(b) By Reason of Facts and Circumstances

(c) Initial Contract Exception

(5) Physicians as Disqualified Persons

c. Excess Benefit Transactions

(1) Definition

(2) Reasonableness Standard

(3) Sources of Compensation

(4) Revenue-Sharing Transactions

(5) Transfer of Property

(6) Other Potential Excess Benefit Transactions

d. Liability of Organization Managers

(1) Definition of Participation

(2) Definition of Knowing

(3) Reasonable Cause and Advice of Counsel

e. Rebuttable Presumption

(1) Approval by Governing Body or Committee

(2) Comparative Data

(3) Documentation

f. Non-Fixed Payments and Caps

g. Section 4958 Excise Taxes

h. Effective Planning

B. Compensation Arrangements

1. Contingent or Percentage of Income Arrangements

2. Physician Recruitment Incentives

a. GCM 39498

b. IRS Guidance

d. Herman Hospital Closing Agreement

e. Rev. Rul. 97-21

3. Below Market Rate Loans and Loan Guarantees

4. Rent Abatement

5. Recruiting Bonuses

6. Support Services

7. Purchase of Physician Practices

8. Personal Expenses

9. Gainsharing Arrangements

a. Benefits and Limitations

b. Federal Income Tax Analysis

c. Fraud and Abuse Issues

10. Joint Ventures

C. Fraud and Abuse Issues

1. Anti-Kickback Law

a. Safe Harbors

b. Fraud Alerts

2. Stark Laws

a. Incentive Compensation Payments

b. Physician Recruitment

D. Documentation

VI. Deferred Compensation and Profit-Sharing Arrangements

A. Historical Background

B. Qualified Plans

C. Nonqualified Plans

1. Tax Sheltered Annuities

2. Deferred Compensation - § 457

VII. Partnerships and Joint Ventures

A. Purposes

B. Forms of Joint Ventures

1. General

2. Choice of Entity

a. Corporations

(1) Formation

(2) Tax Status: C Corporation v. S Corporation

b. Partnership

(1) General Partnership

(2) Limited Partnership

(3) Joint Operating Agreements

c. Limited Liability Company (LLC)

C. Private Inurement/Private Benefit Issues

1. Per Se Position

2. IRS's Current Position

a. Close Scrutiny Standard

b. Control and Whole-Hospital Joint Ventures

c. Community Benefit Standard: Net Revenue Stream

(1) Private Inurement

(2) Private Benefit

(3) Community Benefit

(4) Fraud and Abuse Implications

3. Intermediate Sanctions

D. Unrelated Business Income Tax

E. IRS Examinations

F. Fraud and Abuse

1. GCM 39862

2. Safe Harbor Regulations

a. Personal Service and Management Contracts

b. Lease Arrangements

3. Special Fraud Alerts

a. Contractual Joint Ventures.

b. Rental of Space in Physician Offices

G. Self-Referral Prohibition

H. Unwinding Joint Ventures

VIII. Managed Care Organizations

Introductory Material

A. Health Maintenance Organizations

1. Characteristics

2. Basic Models

a. Staff Model

b. Group Model

c. Independent Practice Association Model

d. Network Model

e. Point of Service

f. Medicaid HMOs and Medicaid Service Organizations

3. Federal Income Tax Status

a. Recognition Under § 501(c)(3)

b. Recognition Under § 501(c)(4)

B. Independent Practice Associations

C. Preferred Provider Organizations

D. Commercial-Type Insurance Organizations

1. Section 501(m)

a. Background to § 501(m)

b. Commercial-Type Insurance

c. Substantial Part v. Incidental Health Insurance

2. Section 833

3. Insurance Companies

IX. Integrated Delivery Systems and Hospital Acquisition of Physician Practices

Introductory Material

A. IDS Formation and Operation

1. Reasons for Creating an IDS and Why Hospitals Buy Medical Practices

2. Basic Models

a. The Foundation Model

b. Hospital Controlled Model

c. Clinic Controlled Model

d. Horizontally Integrated Model

B. Federal Income Tax Issues

1. Qualifications for Tax Exemption

a. Community Benefit

(1) Charity Care

(2) Emergency Room

(3) Governance

(a) Conflicts of Interest

(b) Board of Directors

(4) Committee Composition

(5) Open Staff

(6) Integration of Medical Functions

(7) Medicare/Medicaid Participation

(8) Research and Education

b. Private Inurement

c. Private Benefit

2. Determining Fair Market Value

C. Fraud and Abuse Considerations

1. Anti-Kickback Restrictions

2. Anti-Referral Statute

D. Other Forms of Physician-Hospital Organizations

1. Physician-Hospital Organizations (PHOs)

2. Management Service Organizations (MSOs)

3. Group Practice Without Walls or Clinic Without Walls

X. Unrelated Business Income Tax

A. Statutory Structure of UBIT

1. General

a. "Trade or Business"

b. "Regularly Carried On"

c. "Substantially Related"

2. Deductions and Allocations

3. Exceptions and Modifications

B. Unrelated Debt-Financed Income

C. Controlled Organizations

D. Earning Stripping Rules - § 163(j)

E. Losses and Net Operating Losses

F. Qualified Sponsorship Payments

G. UBIT Issues Affecting Health Care Organizations

1. Health Clubs

2. Laboratory Testing

3. Medical Research Activities

4. Sales of Pharmaceutical Drugs, Supplies, and Durable Medical Equipment

5. Sale of Blood Products

6. Patient and Support Services Provided to Other Hospitals

a. Patient Services

b. Support Services

7. Transactions with Hospital-Based Physicians

8. Captive Insurance Arrangements

9. Rental Income

10. Parking Lot Income

11. Gift and Thrift Shops

12. Cafeteria

H. Agency Relationships

I. Partnerships and Joint Ventures

J. Investment in Subchapter S Corporation

XI. For-Profit Subsidiaries

A. In General

B. Feeder Organizations

1. In General

2. Trade or Business

3. Integral Part

C. Section 512(b)(13) - Controlled Organizations

1. General Exclusion

2. Taxpayer Relief Act of 1997

3. Section 512(b)(13) Before August 5, 1997

D. Attribution of Subsidiary Activities

1. Piercing the Corporate Veil

a. Business Purpose

b. Board of Directors

(1) Overlapping Board

(2) Minority Board Representation

c. Control of Day-to-Day Activities

d. Shared Services and Employees

e. Corporate Formalities

f. Arm's Length Transactions

g. Capital Transfers

2. Agency Principles

E. Section 482

F. Liquidations and Conversion to an Exempt Organization

1. Liquidations

2. Converting from Taxable to Exempt Status

3. Converting from Exempt to Taxable Status

4. Reorganizations

5. Statutory Mergers and Consolidations

6. Joint Operating Agreements

G. Reporting Requirements

H. Subchapter S Election

XII. Tax-Exempt Financing: § 501(c)(3) Bonds

A. Background

B. General Exclusion Rule: § 103

C. Private Activity Bonds

1. Private Business Use Test

a. Limitation on "Private Business Use"

b. Who Is a "User" of Bond-Financed Property

c. Measuring "Use"

d. Types of Use

(1) Ownership

(2) Leases

(3) Management Contracts

(4) Output Contracts

(5) Research Agreements

(a) Corporate-Sponsored Research

(b) Cooperative Research Agreements

e. Special Use Rules

(1) Indirect Use

(2) Incidental Use

(3) Temporary Use

(4) Qualified Improvements

2. Private Security or Payment Test

3. Private Loan Financing Test

4. Anti-Abuse Rule

D. Section 145 - Qualified 501(c)(3) Bonds

1. Ownership Test

2. Private Use

a. Mixed-Use Property

b. Unrelated Trade or Business

(1) Definition

(2) Unrelated Debt-Financed Income

c. Management and Service Contracts

(1) Rev. Proc. 82-14: Management Contracts

(2) Rev. Proc. 82-15: Percentage of Fees Contracts

(3) The Tax Reform Act of 1986

(4) Rev. Proc. 93-19

(a) Compensation Arrangements

(i) Periodic Fixed Fee

(ii) Capitation Fee Arrangements

(iii) Per-Unit Fee Arrangements

(iv) Percentage of Revenue Fee

(b) Related Parties

(5) Regulations and Rev. Proc. 97-13

(a) Arrangements Not Treated as Management Contracts

(b) Compensation Arrangements

(i) 95% Periodic Fixed Fee

(ii) 80% Periodic Fixed Fee

(iii) 50% Periodic Fixed Fee and/or Capitation Fee

(iv) Per Unit Fee Arrangements

(v) Percentage of Revenue Fee

(c) Related Parties

d. Cooperative Sponsored Research Arrangements

3. Former $150 Million Limitation

a. General

b. Test-Period Beneficiary

(1) Definition

(2) Allocation to Principal Users

(3) Related Persons

c. Effect of Allocation and Taxability

d. Qualified Hospital Bonds

4. Residential Rental Housing

a. "First Use" Test

b. Qualified Residential Rental Projects

c. "Substantially Rehabilitated" Test

E. Change in Use

1. General Rule

2. Safe Harbor

F. Other Restrictions and Requirements Applicable to All Issues

1. Public Hearings (TEFRA Hearing)

2. Limitation on Issuance Expenses

3. Information Filing

4. Arbitrage

5. Maturity Restrictions

6. Prohibited Property

G. IRS Scrutiny

XIII. Employment Tax and Employment Status Issues

A. Introduction

B. Employee v. Independent Contractor Classification

1. Instructions

2. Training

3. Integration

4. Services Rendered Personally

5. Hiring, Supervising and Paying Assistants

6. Continuing Relationship

7. Set Hours of Work

8. Full-Time Required

9. Doing Work on Employer's Premises

10. Order or Sequence Set

11. Oral or Written Reports

12. Payment by Hour, Week, Month

13. Payment of Business and/or Traveling Expenses

14. Furnishing of Tools and Materials

15. Significant Investment

16. Realization of Profit or Loss

17. Working for More Than One Firm at a Time

18. Making Service Available to General Public

19. Right to Discharge

20. Right to Terminate

C. Particular Activities and Relationships

1. Hospital-Based Physicians

2. Special Physician Relationships

a. Two-Party Setting

b. Multiple Party Setting

c. Hospital as Employer

d. Hospital-Based Self-Employed Physicians

e. Dual Status

3. Nurses

a. Practical Nurses

b. Student Nurses

c. Nurse Agencies

4. Medical Interns and Residents

D. IRS Examination Guidelines For Hospitals

E. Section 530 Relief

1. General

2. Availability of § 530 Relief

F. Penalties

XIV. Hospital Audits and the Coordinated Examination Program

A. IRS Examination Guidance and Activities

1. Community Benefit

2. Private Inurement and Private Benefit

a. General

b. Unreasonable Compensation and Other Inurement Issues

3. Joint Ventures

4. Unrelated Business Activities

5. Employee v. Independent Contractor Status

6. Financial Analysis

7. Balance Sheet Analysis

B. Team Examination Program for Exempt Organizations

1. Overview of TEP

2. Selection Criteria

3. Planning for the TEP Audit

a. Stage 1: Precontact Preparation

b. Stage 2: Survey of Organization's Books and Records

c. Stage 3: Establishing Examination Procedures

4. Scope and Conduct of Examination

a. The Examination Plan

b. Availability of Records

c. Extension of the Period for Assessment

d. Technical Advice

e. Resulting Audit Report

(1) Agreed Case Procedure

(2) Unagreed Case Procedure

C. Industry Specialization Program

D. Other Audits

1. Selection for Audit

2. Scope and Conduct of Examination

3. Tax-Exempt Bonds

XV. Fund-Raising Activities

Introductory Material

A. Historical Background

B. Token Gift and Free U.S. Government Information

1. Insubstantial Value

2. Qualifying Fund-Raising Campaign

3. Newsletters and Program Guides

4. Low Cost Articles

5. Rev. Proc. 92-49

6. Free Information and Services from the U.S. Government

C. Donor Substantiation Requirements

1. Disallowance Rule

2. Written Acknowledgment

3. Form of Acknowledgment

4. Content of Acknowledgment

5. Timing

6. Penalties and Regulatory Authority

D. Reporting Rules

1. Quid Pro Quo Contributions

a. Definition and Operational Rules

b. Written Disclosure Required

c. "Good Faith Estimate" Defined

d. Certain Goods, Services and Benefits Disregarded

e. Time of Disclosure

f. Exceptions to the Disclosure Requirement

g. Penalties

2. Contributions of Property in Excess of $5,000

E. Deductibility Rules

1. General Rule

2. Admission to Events

3. Raffles, Lotteries, Drawings and Other Contests

4. Auctions and Bazaars

F. Gambling Activities

G. UBIT Consequences

H. Illustrative Examples

XVI. Filing and Disclosure Rules

A. Application for Recognition of Exemption

1. The Application - Form 1023

2. Group Exemption

B. Appeals of Adverse Rulings

1. Protest of Initial Adverse Ruling

2. Appeals Office

3. Declaratory Judgments

a. Background

b. Exhaustion of Administrative Remedies

c. Procedural Matters

C. Form 990

D. Public Disclosure and Inspection

1. General

2. Reasonable Copying Fees

3. Penalties for Failing to Make Return Available to the Public

Working Papers

Working Papers

Table of Worksheets

Editor's Note: The materials listed below are available in the electronic versions of this portfolio.

Worksheet 1 Friendly Hills HealthCare Network Determination Letter (integrated delivery system)

Worksheet 2 Proposed IRS Coordinated Issue Paper on Employee Status of Hospital-Based Physicians

Worksheet 3 Proposed IRS Coordinated Issue Paper on Student Nurse Exclusion from Definition of Employment

Worksheet 4 Health Care Provider Reference Guide IRS Continuing Professional Education Textbook for FY 2004

Worksheet 5 Medicare and Medicaid Anti-Kickback Statute - 42 USC § 1320a-7b(a) and (b) and (f), as amended by P.L. 104-191

Worksheet 6 Anti-Self-Referral Statute - 42 USC § 1395nn (Stark I and Stark II)




Treasury Regulations:

Public Laws:

Treasury Rulings:





















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