Qualification as a nonprofit affords an organization tax benefits in the form of exemptions from federal and, often, state taxes. In addition, most organizations described in section 501(c)(3) of the Internal Revenue Code are eligible to receive tax-deductible contributions.
To be tax-exempt under section 501(c)(3), an organization must be organized and operated exclusively for exempt purposes as set forth in section 501(c)(3), and none of its earnings may inure to any private shareholder or individual. The concept of inurement was present even before the adoption of what we know today as the tax code. In fact, the statutory prohibition against inurement of net earnings first appeared in 1894.
Historically, the IRS has given the rule against inurement and private benefit great significance. So much so that at one time, a tax-exempt social club lost its exempt status because it served lunch and a snack to its members. More recently, the IRS division tasked with ensuring tax-exempt entities comply with relevant tax laws expressed its intent to focus on examining charitable organizations that show indicators of private benefit or inurement in its fiscal year 2018 work plan. Interestingly, a showing of private benefit is one of the most common reasons nonprofits lose or fail to qualify for tax-exemption under 501(c)(3).
This article will discuss the concepts of inurement and private benefit as they impact the nonprofit healthcare sector.
Private Benefit and Private Inurement Distinguished
The private benefit doctrine prohibits a tax-exempt organization from improperly giving monetary or non-monetary benefits to private persons or interests, including those not related to the nonprofit (outsiders). The word “private” has been held to mean the antonym of “public” (i.e. used to distinguish the private individual from the general public). Private inurement is a subset of the private benefit doctrine involving the unjust use of the nonprofit’s income or assets to benefit an insider (that is, a person or company that is closely related to the nonprofit or exercises a significant degree of influence over it).
Private benefit or private inurement can occur in a variety of situations. For example, if a nonprofit organization contracts for services through an outside vendor, the compensation for services cannot be excessive or issues of inurement will arise. In the health care setting where federal Stark and anti-kickback regulations exist, the common terminology used to describe payments for services is “fair market value.” While the IRS has not formally adopted this terminology, it is not uncommon for this concept to make its way into policies and procedures that relate to setting compensation for services.
Both private benefit and private inurement may cause a nonprofit to lose its tax-exempt status. There is no de minimis exception for private inurement. The nonprofit can qualify for a de minimis exception for a private benefit, but only if the benefit to a private person or interest is incidental in both a qualitative and qualitative sense, meaning the private benefit is a mere byproduct of the nonprofit’s charitable activities for the public interest. In application, the qualitative and quantitative analyses by the IRS is rather fluid and subjective. The specific facts and circumstances of the situation are important.
The Evolution of the Nonprofit Hospital: A Historical Perspective
Most hospitals in the United States today are either nonprofit or operated by a government entity. When the first hospitals came into existence in the mid-1700s, they were designed to care for individuals who were not only experiencing physical illness, but also to care for the indigent and mentally ill. At the time, most of the care provided was donated by clinicians, and patients preferred to receive care in the home versus in a hospital setting.
Hospital operations today have evolved substantially since the first hospitals came into existence. According to the American Hospital Association, over 37 million people are now admitted to U.S. hospitals each year. The advent of Medicare and a push for private companies to provide insurance to employees has increased the population of patients with the financial ability to pay for services. Hence, money flowing into the hospitals has increased significantly over time.
There has been debate in the last decade or more about whether hospitals of today should be eligible to qualify and enjoy the benefits of a nonprofit tax designation under Section 501(c)(3). Opponents point to the fact that nonprofit hospitals have higher profit margins than most for-profit hospitals. Further, critics question whether today’s nonprofit hospitals are accurately depicting their charitable impact on the communities they serve by using chargemaster rates (which are generally very high) to calculate charity care.
The Patient Protection and Affordable Care Act (the “ACA”) enacted March 23, 2010, added additional requirements for tax-exempt hospitals to maintain their 501(c)(3) status and came at a time when the nonprofit tax status of hospitals was being scrutinized. The ACA expanded upon the concept of community benefit and added new requirements for nonprofit hospitals codified in Section 501(r). The new regulations attempt to give both the IRS as well as the general public more information on the community benefits provided by nonprofit hospitals.
In February of 2017, the IRS first revoked the nonprofit status of a hospital under the new ACA rules. The unnamed hospital lost its tax-exempt status for failing to conduct the required community health needs assessment, developing and implementing a strategy relating to community benefit, and for failing to make the assessment available to the public.
With increased scrutiny in general on hospital nonprofit tax-exempt status, inurement and private benefit should also be closely monitored by tax-exempt hospitals who want to protect their tax-exempt status into the future.
Excessive compensation paid to officers, directors and employees (including employed physicians) is a common area where issues of inurement and private benefit can arise. Compensation includes more than just salary and can take the form of loans and the value of fringe benefits provided. Fringe benefits can include, for example, the payment of membership dues on behalf of officers or employees, the provision of a company-provided car, or the payment of a forgivable loan or stipend. Of note, payment of excessive compensation of employed physicians by hospitals may, in addition to creating tax issues, potentially violate the Stark physician self-referral law and federal anti-kickback statute.
In determining whether compensation paid to physicians is reasonable, the IRS and courts have traditionally considered both the duties and responsibilities of the physician and also the amounts paid to physicians having similar responsibilities or holding comparable positions at similar organizations. For physicians employed in a clinical capacity, benchmarks such as those prepared by MGMA, Sullivan Cotter, the American Medical Group Association, or others are often used as a way to validate compensation. Hospitals should ensure they use an appropriate survey to ensure they are benchmarking physicians against comparable institutions.
Private benefit and inurement can also involve non-monetary benefits. For instance, if a nonprofit permits use of its facilities for private use that does not support the organization’s nonprofit mission, inurement issues can be triggered. The following are a few practical examples of when non-monetary private benefit or inurement could result:
- A nonprofit hospital designs an outdoor healing garden for use by its patients. The hospital decides to let certain high-net worth private individuals (considered to be potential donors) utilize the space at no cost to host private receptions and weddings. To the extent this use becomes more than incidental, issues of private benefit and inurement could be triggered.
- A member of the hospital board of directors operates a for-profit startup company and is looking for office space as she expands operations. The nonprofit hospital has an unused floor available in a building it leases. The hospital allows the board member and her staff to occupy the floor rent-free.
Electronic Health Records
In August 2006, the Centers for Medicare and Medicaid Services (“CMS”) and the Office of Inspector General for the Department of Health and Human Services (“OIG”) jointly announced new regulations that permitted hospitals to provide electronic health records (“EHR”) technology to physicians until December 31, 2013 without violating the Stark law or anti-kickback statute (the “EHR Regulations”). At the time the EHR Regulations were promulgated, the IRS made no comment about the new regulations’ effect on a hospital’s tax-exempt status. Neither CMS nor the OIG had authority to address whether such an arrangement would violate a hospital’s 501(c)(3) status.
The IRS eventually issued a directive in May of 2007 addressing hospitals’ provision of financial assistance to physicians to acquire or implement an EHR. The IRS specifically addressed the situation where hospitals provide physicians who have staff privileges at those hospitals (“medical staff physicians”) with financial assistance to acquire and implement software that is used predominantly for creating, maintaining, transmitting, or receiving electronic health records for their patients. The IRS clarified that it will not treat subsidies for EHR software and technical support services provided by a hospital to its physicians as an impermissible private benefit or inurement by the hospital in violation of section 501(c)(3) of the Code, so long as certain conditions are met. In June of 2007, the IRS further clarified its EHR guidance by issuing a series of questions and answers on the topic.
Among the key provisions of the EHR Regulations are the requirements that donations include only software, information technology and training services (not hardware); that donated software be interoperable and used “predominantly” to create, maintain, transmit or receive EHRs; and that recipients share at least 15 percent of the cost of the donated items and services.
Telemedicine allows hospitals, health systems and provider groups to connect to their patients remotely through virtual consultations. On February 9, 2018, President Trump signed into law the Bipartisan Budget Act of 20181 passed by Congress. It incorporated the text of the Creating High-Quality Results and Outcomes Necessary to Improve Chronic (“CHRONIC”) Care Act. The CHRONIC Care Act facilitates Medicare reimbursement for telemedicine services in various ways. With increased reimbursement for telemedicine services, hospitals will likely continue to expand their telemedicine offerings.
In providing telemedicine services, nonprofit healthcare providers will need to keep in mind not only the Internal Revenue Code issues, but that the new service lines may also implicate the Stark physician self-referral law and federal anti-kickback statute. Contemplated arrangements will need to meet one of the applicable Stark exceptions and/or Anti-Kickback safe harbors related to services arrangements, and also ensure the relationships do not create private inurement or benefit that could jeopardize the nonprofit’s tax-exempt status.
Nonprofit hospitals are required to be organized and operated exclusively for exempt purposes. The nonprofit healthcare sector has transformed dramatically and nonprofit healthcare organizations are facing increased scrutiny to substantiate their charitable impact. In light of the present environment, nonprofit healthcare organizations should be especially mindful to watch for ussies of inurement and private benefit. While the Stark physician self-referral law and federal anti-kickback statute receive a lot of attention in the health care industry, nonprofit healthcare organizations also need to be mindful of how their activities and relationships could trigger issues of private inurement or benefit in order to protect their nonprofit status.
 See Spokane Motorcycle Club v. United States, 222 F. Supp. 151, 154 (E.D. Wash. 1963).
 See “The Fairy Tale of a Non-Profit Hospital”, Niran Al-Agba, M.D. April 27, 2017 available at https://thehealthcareblog.com/blog/2017/04/25/the-fairy-tale-of-a-non-profit-hospital/
 IRS Final Adverse Determination Letter 201731014 dated February 14, 2017.
 IRS Private Letter Ruling 201017078