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More doctors can have their say in the business.


By Roy Whitehead, Jr., P. Michael Moore, and Joan Pritchard

In Brief

Another Vote for a Simple Majority

CPAs are dealing with the concept of a simple majority of licensed owners of CPA firms that do audits. The IRS is similarly concerned about control by physicians of tax exempt integrated delivery systems. It used to be under IRC section 501(c)(3) that governing board representation by physicians on tax-exempt hospitals and related organizations that deliver health care was limited to 20%. The IRS did not want boards to be able to control the operations of the organizations to the extent they could introduce policies that could lead to the personal benefit of the physicians.

But shouldn't physicians have a strong say in the services that a tax exempt health-care delivery organization delivers to the community. The IRS has reconsidered and new guidelines are more reasonable.

A year or so ago, the IRS announced a significant, and welcome, change to its policy that prohibited extensive physician representation on governing boards of tax-exempt integrated delivery systems (IDS). Previously, in order for an IDS to maintain a tax exempt status under IRC section 501(c)(3), the IRS limited physician board representation to 20% of the board members. This restrictive policy was sometimes referred to as the "20% standard," or the "bright line" standard.

The IRS signaled that it intends to relax the mechanical application of the 20% standard in favor of a policy that allows more physician participation in board governance, coupled with a safeguard requirement that the board adopt a substantial conflicts-of-interest policy to guard against physician members obtaining private inurements. Additionally, the Taxpayer Bill of Rights 2 (P.L 104-168, July 30, 1996) contains provisions that will operate to encourage additional physician participation on governing boards by specifying objective intermediate tax sanctions against individuals who receive an excess benefit rather than imposing the current drastic remedy of loss of tax exempt status for the entire organization.

Tax Exempt Status

Nonprofit integrated delivery system health-care organizations commonly seek Federal tax-exempt status under IRC section 501(c)(3). A health-care organization may be exempt from Federal income taxation if the organization is "organized and operates exclusively for religious, charitable, scientific, or educational purposes" and if "no part of the net earnings of the organization inures to the benefit of a private shareholder or individual." The tax benefits for such organizations include exemption from Federal income taxation, the ability to receive tax deductible contributions, access to tax exempt financing, and often exemption from state and local taxation.

To qualify for an exemption under IRC section 501(c)(3), the health-care organization must be organized exclusively for charitable purposes. The IRS has long recognized the public benefit involved in the promotion of health as a qualifying factor in determining if a health-care entity is organized for a charitable purpose. In Rev. Rul. 69-345 (1969 C.B. 117), the IRS determined that a hospital is engaged in promotion of health of a class of persons broad enough to benefit the community when, among other things, it is governed by a board of trustees composed of independent civic leaders as opposed to physicians or others with a private interest in the organization. The primary purpose of the independent members' requirement is to ensure that members of the board do not receive private inurements from the organization. Private inurement is absolutely prohibited in an exempt organization because IRC section 501(c)(3) expressly provides that no part of the net earnings of the exempt organization can inure to the benefit of a private shareholder or individual. This private inurement prohibition applies to a distinct class of private individuals like doctors who, because of their control of patients and unique relationship with the organization, have an opportunity to control or influence its activities (General Counsel Memorandum 39862--Nov. 21, 1992).

Historically, the IRS has presumed that members of hospitals' medical staffs are insiders when considering the answers to inurement questions. This insider philosophy is expressed in general counsel memoranda 39498 (April 24, 1986) and 39670 (October 14,1987), where the IRS stated that, "all persons performing services for an organization have a personal and private interest in it, and therefore, possess the requisite relationship to establish a private inurement." If the IRS determines that any of the net earnings of a section 501(c)(3) organization have inured to the private benefit of insiders, under current policy, the organization faces revocation of its tax-exempt status.

Inurement Questions

Inurement questions often arise when an exempt organization is pursuing health-care initiatives by buying a practice of a private physician or acquiring a physician's existing assets. In the past, if physicians controlled more than 20% of the board, upon examination of the transaction the IRS automatically presumed the existence of a private inurement. Physicians are troubled by the so-called 20% rule because they view it as an impediment to their playing an influential role in new exempt ventures, hospital management, and health-care initiatives. For example, under the 20% rule it would be impossible to create outstanding and highly regarded physician-run institutions like the Mayo Clinic. Physicians also argue that the IRS restriction on board participation drives physicians away from the exempt sector who are interested in education and research and willing to be subject to a reasonable community benefits standard but unwilling to accept a mere 20% control of the board. The 20% rule makes those physicians believe that they have no control over the medical direction of the organization or they are powerless to control their own destiny. The IRS responded that the 20% rule does not keep physicians from influencing decisions about clinical care, but only properly prohibits physicians from realizing personal profits from the nonprofit health-care entity.

The questions of physician participation on nonprofit hospital boards logically boils down to what is good public policy. Under section 501(c)(3) an organization that operates in a manner contrary to public policy or law is not entitled to an exemption [Bob Jones University v. United States, 461 U.S. 574 (1983), and general counsel memorandum 39862 (Nov. 21, 1991)].

The New Prescription

Comments by IRS Exempt Organizations Division Director Marcus Owens to the American Academy of Health Care Attorneys, on April 25, 1996, and a release of the 1997 IRS exempt organizations continuing professional education text, entitled Community Board and Conflicts of Interest Policy, clearly signal that the IRS is relaxing its restrictive stance on physician representation on boards of directors of tax exempt health-care organizations. The new IRS policy sharply focuses on two factors: first, a factual review of whether the IDS is properly governed by a truly independent board that may contain up to 49% physicians and second, whether the board applies reasonable safeguards against inurement by adopting an appropriately strict conflict-of-interest policy. These two factors, rather than the previous mechanical reliance on a 20% limitation of physician representation on the governing board will be the critical factors examined by the IRS in determining inurement questions.

The key language contained in the new conflict-of-interest policy chapter states that "(i) in a multi-entity hospital system, the board of a subsidiary nonprofit health-care organization is considered to be comprised of independent community members if it is controlled by an exempt organization whose board is comprised of a majority of voting members who are independent community members." In essence, this new standard means that independent community leaders will comprise at least 51% of the governing boards of the IDS. Obviously, the representation of physicians and other interested parties would be limited to the remaining 49% of the governing board of the IDS.

These new guidelines seem to be recognition by the IRS that when exempt organizations behave properly, as most do, there is no logical reason to severely restrict physician representation on governing boards. A convincing argument can be made that physicians should have a substantial say in how an IDS is governed and that restricting experienced physician input is contrary to the community's purpose standard and not in the best interest of health-care consumers.

In order to ensure that new governing boards are avoiding inurement problems, the professional continuing education text requires that the tax exempt health-care organization adopt a substantial conflict- of-interest policy as a safeguard. The policy must include--

Disclosure to the rest of the board of a member's financial interest in business activities;

  • Established standards and procedures for deciding what constitutes a conflict of interest, including having a disinterested person investigate alternatives;

  • Procedures for dealing with a conflict when one is identified (e.g., the board member may be asked to leave the discussion);

  • A policy incorporated into the organization's bylaws that includes keeping records of conflicts and how the conflicts were handled;

  • An internal audit procedure, independent of the normal business activities of the organization that provides for periodic review of compensation, contracts, and business deals by persons who do not receive compensation, directly or indirectly, from the organization.

    The IRS apparently trusts that if a health-care organization has an adequate and enforceable conflict-of-interest policy, the rationale for limiting physician board representation no longer exists. Such a policy demonstrates that the health-care organization is acting to promote the health of the whole community rather than to benefit the private interests of the board members and physicians.

    Taxpayer Bill of Rights

    Fortuitously, for the IRS and the health-care industry, Congress, in Taxpayer Bill of Rights 2 (P.L. 104-168), has provided for intermediate sanctions to deal with situations where private inurement occurs. The new provisions, along with the conflict-of-interest policy, provide the IRS needed flexibility in dealing with inurement issues and enhances the IRS's enforcement without harming the general public.

    In the past, the only sanctions that could be imposed against an exempt 501(c)(3) organization was revocation of the tax exempt status. This was an inappropriate and generally harmful remedy because it might deny health-care services to innocent individuals who had no control over the private inurement. Taxpayer Bill of Rights 2 provides a welcome alternative to this drastic penalty by providing for a new IRC section 4958. Under section 4958(a)(1), a first tier tax is imposed on each excess benefit transaction. The tax is equal to 25% of the excess benefit, and is paid personally by the disqualified individual involved. Of considerable impact, is that whenever the excess benefit tax is imposed on an individual, an additional 10% tax may be imposed on any organizational manager in the transaction who knew of the excess benefit.

    For notice to the general public, exempt organizations will be required to include on their Form 990 information on disqualified persons, excise tax penalties, and excess benefits transactions and to make copies of those returns available for public inspection. Failure to make copies of the returns available can result in fines up to $10,000.

    The IRS Follows Its Own Prescription

    The IRS has already demonstrated, in at least four cases, that it will follow the proposed relaxed standards concerning physician membership on the governing board of a tax-exempt clinic. In a determination letter, released December 2, 1996, concerning North Shore Medical Specialists Clinic of Chicago, the IRS granted a 501(c)(3) tax exemption to a physician-owned outpatient clinic. The outpatient clinic is operated for the purpose of providing primary care to patients of a 501(c)(3) medical center and the community. The clinic agreed to operate in a manner approved in advance by the nonprofit medical center's community board of directors. The IRS concluded that the medical center's community board of directors exercised sufficient control over the physician-owned clinic to insure that it operated for a nonprofit purpose. The critical factor in the ruling was that the clinic's bylaws include a substantial conflict-of-interest policy that demonstrates its promotion of community health, rather than benefiting private interests. The ruling is an indication that the IRS intends to follow the new facts and circumstances approach to physician board representation.

    The North Shore determination followed three other similar rulings involving health-care organizations with physician-board representation where the IRS conducted a facts-and-circumstances examination of governing boards. Perhaps the most instructive is the June 19, 1996, letter to a Texas clinic, the C.H. Wilkinson Physician Network. The clinic was determined to be tax exempt despite the fact that under Texas law it was required to have a board made up solely of physicians. Because the clinic was incorporated by the Sisters of Charity of the Incarnated Word, Houston, an exempt organization that retained the right to approve significant decisions like physician compensation, the IRS determined that the clinic was in fact controlled by the Sister's community board. In making the favorable determination, the IRS specifically stated that it relied on the fact that the clinic's by-laws included a substantive conflict-of-interest policy.

    More Doctor Governance

    The IRS' new policy regarding physician IDS governance encourages enhanced physician direction and influence in the development of IDSs. The new policy permits the IRS to disregard the mechanical 20% rule and properly focus on facts-and- circumstances review of whether the IDS is governed by a board controlled by independent community leaders and applies an appropriate conflict-of-interest policy. Certainly, a facts-and-circumstances review is preferable to an unthinking mechanical rule controlling the level of physician board representation.

    The new IRC section 4958 enacted by the Taxpayer Bill of Rights 2, strengthens the IRS's enforcement policy by providing targeted sanctions against responsible individuals when private inurement occurs. Rather than revoking the tax exempt status of the IDS and harming the entire community, the IRS can focus on the bad actors and protect the health-care organization and its beneficiaries. Because the section provides for a significant 10% tax on any organizational manager involved in the transaction, wise organizational executives will be motivated to spend more time implementing conflict-of-interest policies and documenting insider transactions. Finally, to avoid potential personal liability, excess executive compensation and fringe benefits packages are also likely to get more management attention.

    Perhaps most important, individual intermediate tax sanctions to discipline bad actors, and the requirement to list such activities on Form 990 will enhance public confidence in charitable nonprofit hospitals that must rely on community support. The IRS's new prescription for physician participation in board governance should improve the health of the entire health-care community.

    Roy Whitehead, Jr., JD, LLM, is an assistant professor of business law, P. Michael Moore, PhD, CPA, a professor of accounting, and Joan Pritchard, CPA, an assistant professor of accounting, at the University of Central Arkansas.

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