Nonprofit Tax Exemption

Background

Rationale

Federal tax exemption for charitable organizations has been in existence since the beginning of federal income tax law. This exemption is based on the principle that the government’s loss of tax revenue is offset by its relief from financial burdens that it would otherwise have to meet with appropriations from public funds, and by the benefits resulting from the promotion of general welfare (p. 10).

Statutory Authority

Federal Tax Law. Not-for-profit (NFP) hospitals have never been expressly categorized as tax-exempt organizations under section 501(c)(3) of the Internal Revenue Code. However, these hospitals are able to qualify for federal tax exemption under section 501(c)(3) since IRS and courts have recognized the promotion of health for the benefit of the community—where medical assistance is afforded to the poor or where medical research is promoted—as a charitable purpose. Specifically, NFP hospitals must be organized and operated exclusively for the promotion of health, ensuring that no part of their net earnings inure to the benefit of any private individual, and may not participate in political campaigns on behalf of any candidate or conduct substantial lobbying activities (p. 10).

Federal Regulations. IRS has issued revenue rulings specifying how NFP hospitals can meet federal tax exemption requirements. Prior to 1969, such hospitals had to provide charity care–generally defined as care provided to patients whom the hospital deems unable to pay all or a portion of their bills (p. 11). But a 1969 IRS ruling eliminated that requirement, requiring instead that qualifying NFP hospitals must provide community benefits (CB), which the IRS currently defines as promoting the health of any broad class of people, perhaps including such activities as charity care, health screening, community education about health risks, emergency room services, and basic research.  In the same 1969 revenue ruling, the IRS recognized five factors that would support a NFP hospital’s tax-exempt status (p. 11):

  • Operation of an emergency room open to all members of the community without regard to ability to pay
  • A governance board composed of community members
  • Use of surplus revenue for facilities improvement, patient care, and medical training, education, and research
  • Provision of inpatient hospital care for all persons in the community able to pay, including those covered by Medicare and Medicaid
  • An open medical staff with privileges available to all qualifying physicians.

But subsequent IRS rulings have made clear that tax-exempt status is determined based on the facts and circumstances of each case: neither the absence of particular factors set forth in the 1969 revenue ruling nor the presence of other factors is necessarily conclusive (p. 11).

State Regulations. As of 2007, 15 of the states had CB requirements in statutes or regulations (Fig. 2); 10 of these have detailed CB requirements (Appendix III). Of the 15 states with requirements, 5 states—AL, MI, PA, TX, and WV—specify a minimum amount of CB required for hospitals to be compliant with state requirements (Appendix III).

Some of the 36 states that do not have CB requirements have provisions or other resources related to CB. Some states, including MA, NM, and RI, have CB provisions tied to hospital licensure requirements rather than requirements needed to obtain and maintain tax-exempt or NFP status (Appendix V). At least five states—CT, GA, MN, NV, and OR—require that hospitals periodically report to the relevant authorities the CB they provide but do not require that hospitals actually provide any CB (Appendix VI). At least two states—MA and UT—describe their CB provisions in sources other than statutes or regulations, such as attorney general guidelines or property tax exemption standards (Appendix VII). The foregoing examples are illustrative; they do not represent a comprehensive analysis of states without CB requirements (note 44).

Key Elements

Five special tax provisions benefit NFP hospitals:

  • Exemption from federal and state corporate income taxes.
  • Exemption from state and local sales taxes.
  • Exemption from local property taxes.
  • Tax-exempt bonds: because individual and corporate bond purchasers do not pay individual or corporate income taxes on interest received, hospitals issuing such bonds pay a lower interest rate.  In mid-2006, FP hospitals had a cost of capital of about 12.9 cents per dollar of investment, while NFP hospitals had a cost of capital of only 10.8 cents per dollar of investment. As well, NFP hospitals can use tax exempt debt to finance buildings and equipment that they could have financed by selling their own investment assets. Their decisions to finance operating assets with tax-exempt debt are influenced by their ability to earn an untaxed return on their investment assets that is higher than the interest cost they must pay on the tax-exempt debt.
  • Charitable contributions: because donors may deduct these from their income tax bases, this may induce them to contribute more than they would otherwise.

Scope

In 2006, the majority—59 percent—of the roughly 4,900 nonfederal, acute care general hospitals in the United States were not-for-profit (NFP). But this varies widely by state (from 88% in MA to 32% in TX) (p. 8).  Leaving aside the 23% of hospitals that are publicly owned, NFP hospitals accounted for about 77 percent of private community hospitals in 2003; however, because NFP hospitals are, on average, somewhat larger than for-profits, they accounted for 86 percent of the fixed assets owned by private hospitals.

State and local governments issued about $9.5 billion in tax-exempt private-activity bonds to nonprofit hospitals in 2002. A total of 1,276 hospitals had tax-exempt debt on their balance sheets in 2002.

Enforcement

Defining Community Benefits. Based on an examination of standards and guidance from federal agencies (IRS, CMS), state laws and regulations, and trade organizations (state hospital associations, CHA/VHA, HFMA) about whether to include and how to define different categories of CB, the GAO reached the following conclusions:

  • Consensus exists to include (and how to define)
    • Charity care (p.20).
    • Unreimbursed cost of means-tested government health care programs, such as Medicaid (p.24).
    • Six of the seven groups of other activities regarded as CB: cash and in-kind contributions, CB operations, community health improvement services, health professions education, medical research, and subsidized health services (p. 29).
  • Consensus does not exist about whether to include or how to define
    • Bad debt (p.20).
    • Unreimbursed cost of Medicare (p.24-25).
    • Community-building activities (p. 29).

IRS Form 990. Once NFP hospitals have applied for and are granted tax-exempt status by IRS, they must file Form 990 with IRS on an annual basis. Form 990 collects information such as revenues and expenses, and program service accomplishments (p.12). According to GAO, however, Form 990 does not collect and IRS does not have information on hospitals’ provision of activities that benefit the community in specified categories. “IRS officials indicated that for tax years 2001 to 2006, none of the nonprofit hospital examinations the agency conducted were selected specifically to ascertain whether these hospitals complied with the community benefit standard. Rather, IRS conducted these examinations in the course of the agency’s other work. These officials also told us that some of these examinations were full-scale examinations where in addition to reviewing other issues, IRS conducted a limited review of community benefit focusing on the five factors listed in the 1969 revenue ruling” (note 33).

IRS Form 990, Schedule H. In December 2007, IRS released a revised Form 990 to include a schedule specific to hospitals— Schedule H—that requires NFP hospitals to report their provision of activities that benefit the community in specified categories: charity care, bad debt, unreimbursed cost of government health care programs, and other activities that benefit the community. The new hospital schedule will be mandatory starting in filing year 2010 for tax year 2009, so complete data from the schedule may not be available until 2011, at the earliest (p.12).  But again, GAO asserts that it examined IRS’s final version of the Form 990, which was pending OMB approval at the time their report was issued. “Form 990’s new Schedule H requires nonprofit hospitals to report their provision of bad debt, the unreimbursed cost of Medicare, and community-building activities in Parts II and III of the schedule, but not as part of the Part I quantifiable community benefit table” (note 33).

Medicare Cost Reports. All hospitals that participate in the Medicare program—including NFP hospitals—must file annual hospital cost reports with CMS. The required cost report includes Worksheet S-10, which collects revenue and cost information on Medicaid, state and local indigent care programs, the State Children’s Health Insurance Program, and other uncompensated care (charity care and bad debt) (p.13).

Form 8038. Every state and local government and other authority that issues tax-exempt bonds must file a Form 8038 information return with the IRS that details a bond issue’s dollar value and purpose, as well as other financial information.  Such returns can be used to estimate the volume of nonprofit hospitals’ tax-exempt borrowing in a given year.

State Reporting Requirements.  Some states require hospitals to report their provision of community benefits using state-specific reporting instruments. Of the 15 states with community benefit requirements, four—IL, IN, MD, and TX—have penalties for hospitals that fail to comply with their community benefit requirements (Appendix IV).  Of the 11 states that do not specify a penalty, if the requirement is tied to tax exemption, a nonprofit hospital could be denied tax exemption for a period of time.

For states without community benefit requirements but with community benefit provisions tied to hospital licensure requirements, a hospital that has not complied with the community benefit provisions will not be licensed (or its license may be suspended or revoked). In addition, states may include explicit penalties for failure to comply with community benefit provisions tied to hospital licensure requirements.

Voluntary Reporting Requirements. Some hospitals when requested voluntarily report their community benefits to the state hospital associations or other trade organizations to which they belong.

Policy Impact

  • The Joint Committee on Taxation (JCT) estimated that in 2002, NFP hospitals and their supporting organizations received tax benefits of $12.6 billion at the federal, state, and local levels:
    • $2.5 billion related to federal income taxes and $0.5 billion due to state corporate income taxes
    • $2.8 billion related to state and local sales taxes
    • $3.1 billion related to local property taxes
    • $1.8 billion related to federal bond financing
    • $1.8 billion related to federal charitable contributions
  • Gentry and Penrod (1998) estimated that in 1995, nonprofit hospitals received tax benefits of $7.7 billion at the federal, state, and local levels:
    • $4.6 billion related to income taxes.
    • $1.7 billion related to property taxes exemption
    • $354 million related to benefits from using tax-exempt bonds
    • $1.1 billion (1994) in benefits from charitable contributions.

Resources

Analysis

  • Cogan, John F., R. Glenn Hubbard, Daniel P. Kessler. Healthy, Wealthy, and Wise: Five Steps to a Better Health Care System. AEI Press/Hoover Institution (November 2005). [Table of Contents]
  • Congressional Budget Office. Nonprofit Hospitals and Tax Arbitrage (Washington, D.C.: December 2006).
  • Congressional Budget Office. Taxing the Untaxed Business Sector (Washington, D.C.: July 2005).
  • Duggan, Mark. Hospital Market Structure And The Behavior Of Not-For-Profit Hospitals, RAND Journal of Economics, Autumn 2002; 33(3): 433-446. Also available as NBER paper [Abstract]
  • GAO. Nonprofit Hospitals: Better Standards Needed for Tax
    Exemption
    . Pub. no. GAO/HRD-90-84 (Washington: GAO, 1990)
  • GAO. Nonprofit, For-Profit, and Government Hospitals: Uncompensated Care and Other Community Benefits. GAO-05-743T, May 26, 2005. Summary (HTML)][Highlights Page (PDF)][Full Report (PDF, 32 pages)]
  • GAO. Nonprofit Hospitals: Variation in Standards and Guidance Limits Comparison of How Hospitals Meet Community Benefit Requirements. GAO-08-880, September 12, 2008. [Summary (HTML)][Highlights Page (PDF)][Full Report (PDF, 76 pages)]
  • Gentry, William M. and Penrod, John R. The Tax Benefits of Not-for-Profit Hospitals (February 1998). NBER Working Paper No. W6435. [Abstract]
  • Internal Revenue Service, 1969. Revenue Ruling 69-545, 1969-2 C.B. 117.
  • Wedig, Gerard J., Mahmud Hassan, and Michael A. Morrisey. Tax-Exempt Debt and the Capital Structure of Nonprofit Organizations: An Application to Hospitals. The Journal of Finance 1996; 51(4): 1247-1283.

Organizations

Experts

  • R. Glenn Hubbard, Dean, Graduate School of Business, Columbia University and Visiting Scholar, American Enterprise Institute
  • Daniel P. Kessler, Graduate School of Business, Stanford University and Research Associate, NBER
  • Mark McClellan. Director, Engelberg Center for Health Care Reform and Leonard D. Schaeffer Director’s Chair in Health Policy, The Brookings Institution

Data

Links

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