The Patient Protection and Affordable Care Act (PPACA) was enacted on March 23, 2010, and was revised by the reconciliation bill enacted on March 30, 2010. The PPACA establishes new requirements for section 501(c)(3) hospital organizations under the Internal Revenue Code. This alert discusses those new requirements and in particular comments on implications of those requirements for health care finance.
Even though the new requirements are in most respects a modest revision to the existing standards that apply for a hospital organization to qualify as a section 501(c)(3) organization under the Code, they merit careful consideration.
The PPACA establishes new requirements for any organization that operates at least one hospital facility to qualify as a section 501(c)(3) organization. In general, new section 501(r) of the Code imposes the following new requirements.
These new requirements are generally effective for taxable years beginning after March 23, 2010, except that the requirement for a community health needs assessment is effective for taxable years beginning two years after March 23, 2010.
Failure to complete a community health needs assessment in any applicable three-year period can result in a penalty on the organization of up to $50,000, in addition to possible revocation of status as a section 501(c)(3) organization.
New disclosure requirements. The PPACA also imposes new reporting and disclosure requirements on hospital organizations. Each organization must include in its Form 990 information return a description of how the organization is addressing the needs identified in each community health needs assessment and a description of any such needs that are not being addressed, together with the reasons why such needs are not being addressed. Each organization must also include in the Form 990 its financial statements (or the consolidated financial statements, if applicable). The new disclosure requirements are in addition to the information that hospital organizations are currently required to report using Form 990 Schedule H, which includes questions relating to charity care, community benefits, community building activities and bad debt, Medicare, and collection practices.
Continuing review by IRS and Treasury. The IRS is required to review information about a hospital’s community benefit activities at least once every three years. The PPACA requires the Secretary of the Treasury, in consultation with the Secretary of Health and Human Services (HHS), to submit annually a report to Congress with information regarding the levels of charity care, bad-debt expenses, unreimbursed costs of government programs, as well as costs incurred by tax-exempt hospitals for community benefit activities. The Secretary of the Treasury, in consultation with the Secretary of HHS, must conduct a study of the trends in these amounts, and submit a report on such study to Congress not later than five years after the date of enactment of the PPACA.
The new requirements are modest, or “softer”, additions to the eligibility requirements than certain proposals that have been made in the legislative process. Perhaps most importantly, new section 501(r) of the Code does not subject tax-exempt hospital organizations to a minimum charity care requirement. A minimum charity care requirement was included in a Senate Finance Committee paper outlining options for financing health care, but was not enacted.
In addition, a Senate bill would have required tax-exempt hospital organizations to limit charges to patients receiving financial assistance under a financial assistance policy, and to patients receiving emergency care, to not more than the lowest amount charged to patients who have insurance covering such care. The enacted legislation only requires that charges be limited to the “amounts generally billed.”
The IRS is likely to provide published guidance interpreting the new requirements. Until that guidance is released, statements in the legislative history provide the insight as to how the new requirements will be applied.
Collection processes. The new legislation provides that a hospital organization (or its affiliates) may not undertake extraordinary collection actions against an individual without first making “reasonable efforts” to determine whether the individual is eligible for assistance under the hospital’s financial assistance policy and specifically directs the Treasury Department to issue guidance concerning what actions constitute reasonable efforts. It is intended that reasonable efforts includes notification by the hospital of its financial assistance policy upon admission and in written and oral communications with the patient regarding the patient’s bill, including invoices and telephone calls, before collection action or reporting to credit rating agencies is initiated. The legislative history states that extraordinary collection actions include lawsuits, liens on residences, arrests, body attachments, or other similar collection processes.
Limitation on charges. Amounts billed to those who qualify for financial assistance may be based on either the best, or an average of the three best, negotiated commercial rates, or on Medicare rates.
Definition of a “hospital.” For purposes of these new requirements, a hospital facility generally includes (1) any facility that is, or is required to be, licensed, registered, or similarly recognized by a state as a hospital; and (2) any other facility or organization the Security of the Treasury, in consultation with the Secretary of HHS and after public comment, determines has the provision of hospital care as its principal purpose.
Among the interpretive questions that could be addressed in IRS guidance are the extent to which compliance with certain of the requirements can be met by the good faith adoption of policies and procedures, even if, in actual implementation, the policies and procedures are to a degree not followed. For example, the new provision of the Code provides that an organization must “establish” a “financial assistance policy,” but does not specifically detail the consequence if the policy is not actually followed to some degree. The legislative history states that the requirement is that an organization must “adopt, implement and widely publicize” such a financial assistance policy.
The requirement regarding limitation of charges is described in the legislative history as met if each hospital facility “is permitted to bill” for charges in the restricted manner. This wording could be read to suggest that the requirement could at least in large part be met by the good faith implementation of a policy or procedure, even if the policy is not actually followed in every instance.
On the other hand, the new billing and collection requirements are framed in a manner that appears to place more emphasis on compliance based on actual conduct, as compared to good faith implementation of policies and procedures.
In order to preserve its status as a section 501(c)(3) organization, a hospital organization will need to very promptly adopt and implement at least the required procedures relating to financial assistance, limitations on charges, and collection processes (or to review existing procedures to determine that they comply in all respects with the new requirements). A hospital organization is permitted an additional two-year period to adopt and implement community health needs assessments (or to review existing procedures and assessments to determine that they comply with the new requirements).
Because the consequences of failure to comply can be severe, in most cases hospital organizations will want to strictly comply with the new requirements and will need to take into account the guidance expected to be published by the IRS interpreting the new requirements in greater detail.
The enactment of section 501(r) of the Code represents the latest chapter in a long-running debate about the appropriate federal income tax standards for tax-exempt hospital organizations. A helpful summary of this history is set forth in a 2009 report of the Congressional Research Service on “501(c)(3) Hospitals and the Community Benefit Standard.”
In 1969, the IRS issued Revenue Ruling 69-545, which eliminated from a prior revenue ruling the requirement that a hospital provide free or reduced care. Under the “community benefit” standard developed in Revenue Ruling 69-545, hospitals have been judged on whether they promote the health of a broad class of individuals within the community. According to Revenue Ruling 69-545, community benefit can include, for example: maintaining an emergency room open to all persons regardless of ability to pay; having an independent board of trustees composed of representatives of the community; operating with an open medical staff policy, with privileges available to all qualifying physicians; providing charity care; and utilizing excess funds to improve the quality of patient care, expand facilities, and advance medical training, education, and research.
In 1983, the IRS issued Revenue Ruling 83-157, which further explained the community benefit standard. Revenue Ruling 83-157 states that a hospital without an emergency room may still qualify for exempt status if other conditions are met.
The new requirements of section 501(r) are in addition to, and not in lieu of, the requirements otherwise applicable to a section 501(c)(3) organization, including the existing community benefit standard.
The community benefit standard has been the subject of controversy since its date of adoption. For example, shortly before the adoption of Revenue Ruling 69-545, legislation was introduced to Congress to provide for express rules for section 501(c)(3) hospital organizations and, shortly after the adoption of Revenue Ruling 69-545, the standard was challenged in litigation.
In recent years, a number of different bills have been introduced to provide specific requirements for section 501(c)(3) hospital organizations. In 2006, the IRS sent questionnaires to approximately 600 large hospitals to collect information on how hospitals operated and what types of community benefit they provided. In part as a result of this initiative, the IRS subsequently announced that hospitals would be required to provide additional information on a new Schedule H of the redesigned Form 990. Beginning in 2009, hospital organizations generally are required to submit information on community benefit on their annual Form 990 information returns.
There is little reason to have confidence that the enactment of the new requirements in section 501(r) will resolve the long-running debate about the appropriate federal tax standards for tax-exempt hospital organizations, and it appears likely that proposals for additional requirements will be made in the future.
A 2006 report of the Congressional Budget Office on “Nonprofit Hospitals and the Provision of Community Benefits” estimated the annual value of tax exemptions provided to nonprofit hospitals in 2002 to be as follows:
Corporate Income Tax (Federal)
Tax-Exempt Bond Financing (Federal)
Charitable Contributions (Federal)
Corporate Income Tax (State)
Sales Tax (State and Local)
Property Tax (Local)
The tax benefits to any particular hospital organization will depend upon its particular facts and circumstances, so that in some cases one type of benefit may be much more significant than the others.
It merits particular emphasis that the new provisions for section 501(c)(3) hospital organizations that are set forth in 501(r), like other section 501(c)(3) requirements, generally are “all-or-nothing” requirements. That is, if an organization fails to meet all of the requirements, the organization forfeits all of the federal tax benefits from tax-exempt status, at least with respect to the hospital facility. The legislation provides that, if an organization fails to meet the requirements for a facility, then it will not be treated as a section 501(c)(3) organization “with respect to any such facility.” Thus, it is possible that in some cases certain of the adverse tax effects resulting from failure to comply could be limited to a hospital facility owned by an organization, rather than the entire organization, depending upon the facts and circumstances and how the IRS interprets this provision.
The new legislation does provide that failure to complete a community health needs assessment in any applicable three-year period results in a penalty on the organization of up to $50,000. Although it is possible that the IRS could choose to impose this penalty on a noncompliant organization rather than revoke the tax-exempt status of the organization, the penalty is literally framed as a penalty in addition to loss of tax-exempt status. In addition, an organization failing to meet the new disclosure requirements could be subject to existing incomplete return penalties.
One important lesson to be taken from the new legislation is that hospital organizations now appear to be subjected to heightened change of law risk. Congress has shown its willingness to enact special statutory requirements for tax-exempt hospital organizations. In addition, the statutorily mandated periodic review and submission of reports relating to community benefit provided by section 501(c)(3) hospital organizations may increase the likelihood that Congress will consider additional requirements for section 501(c)(3) hospital organizations in the future and may increase IRS scrutiny of particular 501(c)(3) hospital organizations with the applicable requirements. Change of law risk may be particularly heightened five years from now, when the Treasury Department and HHS are required to submit a report on community benefit to Congress.
The legislation provides for a limited phase-in of the new requirement for the community needs assessment. The new rules provide for no grandfathering of existing arrangements. The fact that grandfathering rules appear not to have been seriously discussed in the legislative process may be taken as one indication that Congress understood the changes to be modest additions to existing standards, rather than fundamental changes.
A comparison to transitional rules in other major tax legislation is instructive. For example, the Tax Reform Act of 1986 (TRA) fundamentally changed the eligibility requirements for tax-exempt bonds issued for the benefit of 501(c)(3) organizations. Among other things, the TRA dramatically decreased the amount of “private business use” permitted for a bond issue (from 25 percent to five percent) and imposed a new requirement that all bond-financed property must be owned by a section 501(c)(3) organization or a state or local government. Congress was aware that many bonds issued before the effective dates of the TRA would not meet these new requirements and recognized the importance of grandfathering then-outstanding bond issues to avoid disrupting the tax-exempt bond markets and to deal fairly with organizations that had issued tax-exempt bonds in reliance on the prior requirements. Accordingly, the TRA contains an elaborate set of transitional rules that provide that bonds issued before the relevant effective date (and certain bonds that subsequently refund those bonds) are not subject to the stricter eligibility requirements.
For bonds subject to the requirements of the TRA, all of the bond-financed property must be owned by a section 501(c)(3) organization or a governmental unit. Accordingly, the failure of an organization benefiting from tax-exempt bond financing to continue to qualify as a 501(c)(3) organization ordinarily results in loss of the tax-exempt status of the bonds, possibly from the date of issuance of the bonds. In general, tax-exempt bonds are subject to the same type of “all-or-nothing” rule as tax-exempt hospital organizations: Failure to comply with the requirements applicable to a bond issue, even to a small degree, could result in the entire bond issue failing to comply.
The applicable federal income tax regulations provide for a framework for how the tax-exempt bond use-of-proceeds rules apply to this type of bond issue. In general, a borrower must both (1) reasonably expect on the date of issuance that the bond issue will meet the use-of-proceeds requirements throughout the term of the bond issue and (2) must not take any deliberate action during the term of the bond issue that results in noncompliant use.
If a borrower does take a deliberate action that results in noncompliant use during the term of the bond issue, the borrower is generally permitted to take certain remedial actions to preserve the tax-exempt status of the bond issue, provided those actions are taken promptly after the deliberate action. The permitted remedial actions include early redemption or defeasance of the portion of the bond issue that fails to comply (the nonqualified bonds) and, in some cases, use of the proceeds received from a cash sale or other disposition for other qualifying purposes.
First, on the date of issuance of any new tax-exempt bonds, the borrower must reasonably expect to meet all the eligibility requirements for a section 501(c)(3) organization, including the new requirements of section 501(r), throughout the term of the bond issue. That means that, on the date of each new bond issue, the borrower must now have a high degree of confidence that it will meet the new requirements for long periods of time. As a general matter, it would be appropriate for a borrower to specifically represent in bond documents that it intends to meet the requirements of section 501(r) for the entire term of the bond issue.
Second, any failure of a benefited organization to meet the new requirements will likely be treated as a deliberate action resulting in loss of tax-exempt status on the bonds, unless an appropriate remedial action is promptly taken. In most cases, the permitted remedial action would likely be only early redemption or defeasance of the nonqualified bonds. Particularly in the case of outstanding bonds that are not currently subject to optional redemption (that is, bonds that are “call protected”), the establishment of a defeasance escrow could entail considerable cost.
The long time horizon for tax-exempt bond compliance. The tax-exempt bond use-of-proceeds requirements in general apply continuously over the entire term of a bond issue. Because tax-exempt bond issues commonly have final maturities of 30 years or more, the period of required compliance is typically very long. Largely for that reason, almost all tax-exempt bond issues are subject to bond document covenants that require the benefited organizations to maintain their status as section 501(c)(3) organizations during the period bonds are outstanding. Failure to maintain section 501(c)(3) status typically would result in a bond document default. In most cases, a borrower of tax-exempt bonds could not choose to fail to meet the new requirements for section 501(c)(3) organizations unless it promptly took the remedial action of redeeming or defeasing tax-exempt bonds, which could be costly. This means that, in many cases, failing to meet the new requirements will not be a practical option.
By contrast, a hospital organization that is not a user of tax-exempt bond proceeds often could choose to forfeit its corporate income tax exemption and ability to qualify as a recipient of deductible charitable donations without the same type of long-term contractual constraints.
Compliance “foot faults” may foreclose or significantly delay tax-exempt financing. The marketing of tax-exempt bonds typically requires an “unqualified”; legal opinion of bond counsel to the effect that interest on the bonds is tax-exempt for federal income tax purposes. In the case of tax-exempt hospital bonds, the bond counsel almost always requires an unqualified opinion from the borrower’s counsel to the effect that each organization benefiting from the financing qualifies as a section 501(c)(3) organization. In addition, in the case of refunding bonds, bond counsel typically requires express representations or an opinion to the effect that each organization benefiting from the refinancing has qualified as a section 501(c)(3) organization for the period of time the prior bonds were outstanding.
The new requirements in section 501(r) of the Code are in general much more specific and detailed than the more qualitative requirements set forth under the community benefit standard. The new requirements do not contain any provision to the effect that substantial compliance with the new requirements is sufficient. A failure to meet any of the new specific “bright line” requirements, even if more technical than substantive, could have the result of foreclosing or delaying a tax-exempt financing. In addition, a failure to meet any of these new specific requirements could result in a technical default under bond documents for outstanding bonds, with potentially costly and complicated consequences.
In such situations, it is possible that the IRS would entertain requests for voluntary closing agreements to conclusively protect the tax-exempt status of a hospital organization, in the same manner that the IRS currently entertains voluntary closing agreement requests for violations of the tax-exempt bond requirements. Obtaining such a voluntary closing agreement, however, could lead to significant delays.
Accordingly, the interplay between the new requirements of section 501(r) of the Code and existing tax-exempt bond requirements as a practical matter greatly increases the need to strictly comply with the new requirements.
As is discussed above, the risk that Congress will in the future enact additional requirements for tax-exempt hospital organizations remains, and may even be increased, by the enactment of section 501(r). In particular, the structure of the new legislation invites a reconsideration of these requirements five years from now. In part because Congress did not appear to seriously consider any provisions protecting the tax-exempt status of outstanding tax-exempt bonds after enactment of the new requirements, it appears that Congress may have assumed that at least the very large majority of tax-exempt hospital organizations will be able to meet the new requirements.
If Congress were in the future to enact more fundamental new requirements, such as a mandatory charity care requirement, it is more likely that meeting the new requirements would not be viable for a significant portion of tax-exempt hospital organizations. In such a scenario, it is likely that Congress would consider the treatment of outstanding tax-exempt bonds under such a regime and at least consider permitting some degree of grandfathering bonds issued before the effective date.
The increased change of law risk suggests that organizations should give renewed consideration to this risk in structuring financings. For example, because of current market conditions, many organizations are currently considering structuring financings with short-term “bullet maturity” financings, with the intent that these bullet maturity bonds will be refinanced at their maturities. Although such a structure may have financial benefit, it also may be prudent to consider change of law risk in selecting such a financing structure.
Michael G. Bailey
Mark T. Schieble
San Francisco, California
Richard F. Riley, Jr.
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