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GT Alert

IRS Increases Enforcement Activity for Non-Profits; Congress Examines Exempt Hospitals

August 2005

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IRS Examines Tax-Exempt Compensation

Late last year, the Tax-Exempt and Government Entities Division of the Internal Revenue Service announced that its top priority for 2005 was to strengthen its enforcement presence within the tax-exempt community. It launched the Tax-Exempt Compensation Enforcement Project, and will have contacted approximately 2,000 tax-exempt organizations by year end with inquiries as to the compensation paid (generally for the year 2002) by those entities. The IRS will then commence audits of selected organizations. In late July, the Commissioner of the Tax-Exempt and Government Entities Division announced that the Division expects to conduct approximately 1,400 examinations of exempt organizations per year for the foreseeable future. The Division’s budget has been increased by almost 10 percent to support this effort.

“...the Commissioner of the Tax-Exempt and Government Entities Division announced that the Division expects to conduct approximately 1,400 examinations of exempt organizations per year for the foreseeable future.”

A tax-exempt organization is always permitted to pay reasonable compensation for the services it receives. High compensation may be paid, provided it is warranted by the value of the services performed for the exempt organization. In order to determine what is reasonable, the organization must look to what similar organizations pay for similar work. The focus of IRS inquiry is the exempt organization’s compensation practices and procedures for determining what is “reasonable,” including the manner in which executive compensation is reported. In addition to general compensation practices, however, IRS inquiries have also focused on the amounts earned by the five highest paid officers, directors, employees and independent contractors, or their related entities.

An organization that overcompensates key people may suffer revocation of its tax-exempt status. More likely is the imposition of “inter-mediate sanctions,” penalties imposed under Internal Revenue Code Section 4958 on a recipient of excess compensation where the recipient is a senior level executive. Penalties can be as much as 200 percent of the excess compensation. In addition, penalties can be imposed on directors who knowingly approve the excess compensation. See GT Alert, February 2002, IRS Finalized Intermediate Sanctions Regulations, for a more detailed discussion of intermediate sanction penalties.

Changes have been made to the Form 990 (annual information return) regularly filed by exempt organizations to allow the IRS to more effectively gather and evaluate compensation data. More extensive changes, directed at improving compensation policy practices, will likely be included in the 2007 version of the form. The IRS has stated that it expects reporting of loans, “sweetheart” deals, deferred compensation and various perks to have been inappropriate in many cases.

Many organizations may discover inadvertent failures to report particular benefits as compensation. Unfortunately, such unreported benefits will be deemed “automatic” excess benefit transactions in the eyes of the IRS. Transactions deemed automatic excess benefits are subject to penalties, regardless of whether the compensation involved is reasonable. If an exempt organization discovers such a failure, it should immediately issue a corrected W-2 to the individual whose compensation was underreported.

“One way for an exempt organization to reduce the risk of an unfavorable audit is to conduct, or have counsel conduct, a thorough review of its compensation policies now.”

One way for an exempt organization to reduce the risk of an unfavorable audit is to conduct, or have counsel conduct, a thorough review of its compensation policies now. Procedures for setting compensation for executives, and the comparability of the package offered relative to what similar organizations are paying, should be documented. At a minimum, the IRS will expect such procedures to include (1) advance approval by an independent body, (2) reliance on comparables and (3) adequate concurrent documentation of compensation decisions. Compensation awarded under such procedures is afforded a presumption of reasonableness. An independent and informed board committee (or other governing body) approving compensation remains key to good practice.

Other enforcement issues of high priority to the IRS are post-issuance compliance by tax-exempt bond issuers (with ‘95-’96 bonds likely to receive attention first) and participation by tax-exempt entities in tax shelter transactions. It is hoped that the IRS will pursue an educational, rather than punitive, approach to these cases.

Congressional Hearings on Tax-Exempt Hospitals

The House Ways and Means Committee has recently held hearings on tax-exempt standards for hospitals. The Committee Chairman, Rep. Bill Thomas (R-CA), described the question as “(W)hat is the taxpayer getting in return for the tens of billions of dollars per year in tax subsidy?” Health-related entities account for almost 60% of the total revenues of Section 501(c)(3) organizations. Tax-exempt hospitals account for three quarters of the revenues of all health-related organizations.

Chairman Thomas noted the trend of the IRS to lessen the requirements for a hospital to obtain tax-exempt status. For federal tax exemption, a hospital is not required to provide charity care. In 1983, the IRS dropped the requirement to maintain an emergency room. Thus, the Committee is asking whether there really is a community service mission that differentiates tax- exempt hospitals (which seem to engage in increasingly commercial behavior) from for profit hospitals. Certainly the provision of health care is common to both types of organizations, but the charitable component has been eroded.

The Senate Finance Committee, under Chairman Grassley, is conducting its own survey of at least ten tax-exempt hospital systems to gather information on actual practices. Fact-finding with regard to the provision of charity care and the exempt hospitals’ costs and manner of charging for such care are the focus of the Committee’s efforts.

It should be noted that the same issues have been examined in several states with regard to property tax exemptions of hospitals. In many states, more is required of a hospital to maintain tax-exempt status, including providing charity care of a certain amount. Usually, the test is that a parcel of real estate owned by a tax-exempt entity must be used exclusively for exempt purposes to qualify for a property tax exemption. This is the “quid pro quo” for being exempt from local property taxes.

Illinois has recently been active in challenging the property tax exemptions of health-related exempt organizations. In reported cases, an important factor was the absence or insignificance of the charity care provided. See e.g. 4/21/05 recommendation of Champaign County Board of Review (as reported in the BNA Daily Tax Report 4/26/05) that property tax exemptions for Carle Foundation Hospital and related entities be denied (charity care was less than .5%); Eden Retirement Center Inc. vs. Dep’t. of Revenue (Illinois Supreme Court 12/2/04); Illinois Department of Revenue vs. Provena Covenant Medical Center, No. 01-PT-0014.

What’s Next?

“The recent congressional hearings on tax-exempt organizations calling for more regulation of the non-profit sector is evidence of the growing interest in Washington in tax-exempt organizations.”

We expect in this day of large federal deficits and general concerns over the merits of the nonprofit sector and the implicit subsidies that tax exemption provides, that the merit of continuation of tax exemption would be the subject of examination. The recent congressional hearings on tax-exempt organizations calling for more regulation of the non-profit sector is evidence of the growing interest in Washington in tax-exempt organizations. All of these hearings may produce legislation that will have significant impacts on the non-profit sector in general and tax-exempt hospitals in particular. Interested persons should continue to pay attention to this trend. The report presented June 22, 2005 to the Senate Finance Committee by The Panel on the Non-profit Sector is designed to help tax-exempts increase accountability and integrity by outlining steps to ensure that the board of directors understands and can fulfill its ethical and financial duties (including independent auditing) in promoting the charitable mission of the organization. The full report is available at www.NonprofitPanel.org.

Similar efforts are underway on the state level. Legislative activity this year in Colorado, Connecticut, Kansas, Massachusetts, Minnesota, New York and North Carolina has included charitable reforms. Effective January 1, 2005, California enacted the California Non-profit Integrity Act, which requires certain charities to form an audit committee and prepare audited financial statements subject to strict independence requirements. This Sarbanes-Oxley style legislation is the first accountability law aimed specifically at non-profits. It seems unlikely to be the last.

 

This Alert was written by Tracy Green Landauer in the New York office and Harry J. Friedman in the Phoenix office. The Alert also describes recent Congeressional questioning of the merits of tax exemptions for hospitals. Please contact Ms. Landauer at 212.801.6863 or Mr. Friedman at 602.445.8000 or your Greenberg Traurig liaison if you have any questions regarding the subject matter of this Alert.

© 2005 Greenberg Traurig


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This GT ALERT is issued for informational purposes only and is not intended to be construed or used as general legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clients’ individual legal needs.