Statement of John Colombo, Professor, University of Illinois College of Law, Champaign, Illinois

Testimony Before the Full Committee
of the House Committee on Ways and Means

May 26, 2005

Mr. Chairman, Members of the Committee:

My name is John Colombo.  I am a professor of law at the University of Illinois College of Law in Urbana-Champaign, and I have taught about and written on issues of tax-exempt organizations for the past 18 years, particularly issues of tax-exemption for nonprofit hospitals.  I want to give you some history and context regarding hospital tax exemption rules and perhaps suggest some alternatives to our current system.

History of Income Tax Exemption for Hospitals

Hospitals have enjoyed exemption from the federal income tax virtually since the beginning of the income tax system.[1]  Prior to 1969, federal income tax exemption for hospitals (and presumably other health care providers) was tied to free care for the uninsured poor (“charity care”).  The official ruling position of the Service was set forth in Rev. Rul. 56-185, which required a hospital seeking exemption under Code Section 501(c)(3) to be “operated to the extent of its financial ability for those not able to pay for the services rendered.”[2]  While the Service never took an official position regarding how much charity care was “enough” or even how to define charity care for these purposes, if a hospital lacked a substantial charity care program, auditing agents almost always recommended denial or revocation of exempt status.[3]  This charity care standard reflected the long-held stance of the IRS (and centuries of legal precedent in the charitable trust arena) that the “relief of the poor” constituted a charitable purpose.[4]

Concurrent with Congressional consideration of the Medicare and Medicaid legislation in the mid-1960’s, however, exempt hospitals began pushing the IRS for reconsideration of exemption standards.[5]  The common complaint (almost hilarious, in retrospect, for its inaccuracy) was that between private medical insurance and the “new” Medicare and Medicaid programs, there simply would not be enough of a demand for charity care to satisfy the IRS, and hence exemption standards should become more flexible in order to maintain exempt status for hospitals.[6]  One wonders, of course, why the most appropriate response to these arguments was not “well, if there isn’t any need for charity care, then there isn’t any need for exemption,” but young staff attorney with the IRS, Robert Bromberg, apparently took the complaints of the hospital industry seriously and began work on a new exemption standard.[7]

This new standard appeared in Rev. Rul. 69-545,[8] which quickly became known as the “community benefit” standard.  This ruling abandoned charity care as the touchstone of exemption.  Instead, citing the law of charitable trusts, the IRS held that the “promotion of health” for the general benefit of the community was itself a charitable purpose, even though some portion of the community, such as indigent patients, were excluded.[9]  Factors that indicated that a hospital met the community benefit test included a community board, an open medical staff, treatment of Medicare and Medicaid patients, and operation of an emergency room that provided emergency treatment to charity patients.[10]  Charity care other than emergency treatment, however, was not required, and in a 1983 ruling, the IRS held that even hospitals without emergency facilities could qualify for exemption under the community benefit approach.[11]

Though Rev. Rul. 69-545 implied that offering health services to all paying patients was sufficient to earn tax exemption, the IRS subsequently took the position in a series of cases dealing with HMO’s that that providing health services to all paying patients (including Medicare/Medicaid patients) is insufficient to justify exemption; rather, some additional “plus” is needed, such as charity care, health education programs or health research programs.  Courts have recently agreed.  The most recent case on this front involved HMO’s formed by Intermountain Health Care in Utah.[12]  The10^th Circuit adopted this “health care plus” formula, denying exemption to an HMO whose membership was open to everyone in the community, because the HMO did not have any significant “plus” such as a charity care program, medical research program or health education program.  What “plusses” will satisfy this test (and more importantly, the amount of resources that must be dedicated to the “plus”) is still an open question, however.

Problems with Community Benefit

In retrospect, the community benefit standard for exemption has proven to be an unmitigated disaster both as tax law and as health care policy.  As law, the main problem with the standard is that it lacks accountability; the standard simply does not require any measurable difference in behavior from a for-profit entity.  Under the 1969 and 1983 rulings, a hospital is eligible for tax exemption if it has a community board, open medical staff, and treats Medicare/Medicaid patients.  None of these criteria, however, focus on actual performance differences between exempt and for-profit hospitals – for example, even for-profit health care providers treat Medicaid patients.[13]  This lack of substantive criteria to differentiate an exempt nonprofit hospital from a for-profit one is undoubtedly what led the IRS to litigate the meaning of the standard in HMO cases – after all, if simply treating paying patients is a charitable purpose, then any for-profit health care provider is a “charity” under this standard.  Yet the recent “health care plus” formulation of the 10^th Circuit doesn’t really add much to what we already knew.  Perhaps it is now clear from the IHC case that simply treating paying patients isn’t enough to get exemption, but even in 1983 the IRS opined that “the application of any surplus to improving facilities, equipment, patient care, and medical training, education, and research, indicate that the  hospital is operating exclusively to benefit the community.”[14]  In short, virtually anything a nonprofit hospital does with surplus funds might be a community benefit, and even supporters of the community benefit standard have admitted that definitions of community benefit remain “inconsistent, narrow, fragmented and only loosely related to the ways in which communities actually affect the health of their residents.”[15]

What we do know is that many of the behaviors touted by the nonprofit hospitals community as “community benefits” are really nothing more than what any good business would do to lure paying customers or stay in tune with their customer base.  Hospitals, for example, claim that community needs assessments and community health education programs are “community benefits.”  But a community-needs assessment is analogous to market research regarding what services are in most demand; if a local automobile dealer did a “community needs assessment” for transportation services, we’d call this a marketing study.  Similarly, many health education and screening programs, such as a pre-natal care program, are also good business – women who enroll in a particular hospital’s pre-natal education program are very likely to choose that hospital for delivery services – which the hospital will make money on. 

Finally, the community benefit standard ignores the fact that taxes paid by for-profit hospitals themselves constitute a major community benefit.  In fact, one academic study noted that if we included the taxes paid by for-profit hospitals as a community benefit, for-profit hospitals actually provide more community benefits than their nonprofit counterparts.[16]

So we are entitled to ask, I think, “What are we getting for the billions per year that we lose in tax revenues as a result of exemption?”[17]  The answer to this is that as a legal matter, we are getting nothing specific other than nonprofit form and a community board.  Community benefit does not provide us with a benchmark against which we can hold nonprofits accountable for their performance; instead we simply trust nonprofits to do a better job by virtue of their form.

Now we might be happy with this “trust us” approach if we really believed that nonprofit form was inherently superior to for-profit form for the delivery of health services, so that no accountability was needed.  If we believed this, we might simply say that tax-exemption is a way to “buy” the superior nonprofit form.  But there is no reason to believe that is the case.  Empirical studies on quality of care, costs of care, and free care for the poor show decidedly mixed results, with some studies finding in favor of nonprofits and others finding in favor of for-profits.[18]  These studies certainly do not prove that nonprofit form is better than for-profit form; at best, all we can conclude is that nonprofits in some markets in some measures outperform for-profits, and that in other markets on other measures, for-profits outperform nonprofits.  It is far more likely that geography, size and market competition affect behavior than simply nonprofit form.  So if we are looking to empirical evidence to justify the “trust me” approach of community benefit, the evidence simply isn’t there.

As health policy, this lack of accountability also leads to the inevitable horror stories.  In my own back yard, the Illinois Department of Revenue recently revoked state property tax exemption for Provena-Covenant Hospital in Urbana, Illinois.  The reason was that for some period of time, Provena essentially hid its charity care program from patients; instead, it had a policy of billing all patients for services rendered, instituting bill collection proceedings against them (which in Illinois, permitted the use of “body attachments” – arresting people if they missed a court date on an uncollected debt), and then, after all that, if collection efforts were exhausted and the person still couldn’t pay, the hospital would write off the bill and call it “charity care.”  The most distressing thing about Provena-Covenant for me as an expert on federal tax exemption is that throughout this entire ordeal, Provena kept touting in the press reports that even though the State of Illinois had revoked its property tax exemption, it still met the standards for exemption under federal tax law – and Provena’s statement on this point was absolutely correct.  From a federal tax perspective, I think we should be both embarrassed and horrified that an organization operating the way Provena did nevertheless could legitimately claim it had met federal exemption standards under the community benefit test.

Alternatives to Community Benefit

If community benefit isn’t the answer, then the next question concerns what alternatives are available.  I think there are three possibilities, each of which admittedly carry some drawbacks but any of which are better than our current law.

A.   A Strict Charity Care Standard

One alternative to the community benefit standard is to return to a charity care formula for hospital tax exemption.   At least one state, Texas, has enacted specific charity care standards for exempt hospitals.  A strict charity care approach certainly would provide an administrable standard of accountability for nonprofit hospitals.  In crafting such a standard, however, a number of practical issues would have to be resolved.  These issues include whether to measure charity care on the basis of costs or charges, and if on costs, whether to use marginal or average costs;[19] what the minimum level of charity care would be to justify exemption; whether that minimum level would have to be in excess of what for-profits write off each year in bad debt (since presumably this is the baseline of “free care” that is being provided by the for-profit providers without tax exemption); and whether nonprofits should have to separate “true” charity care from bad debt in making a charity care measurement (e.g., whether the measurement should be total uncompensated care or a more narrow subset of uncompensated care involving up-front decisions that a patient is a “charity” patient and will not be charged for service).[20]  These issues are simply matters of policy choices and certainly can be resolved, but they in fact must be resolved in order for a charity care standard to work.   

In addition, there are some more general policy questions with respect to a charity care approach.  First, since free care has to be provided by reallocating revenues from other sources, some commentators argue that this essentially involves a “hidden tax” on paying patients and 3d-party and government insurers.  Moreover, this “tax” is being assessed by private actors (hospitals) instead of through normal democratic processes.[21]

Second, whether charity care is available and how much is available will be dictated by the local market and the success (or lack thereof) of hospitals in that market in reallocating revenues from other sources.  Thus availability of care may vary enormously depending on geographic location.

Third, while a strict charity care standard is a viable solution to the accountability problem with tax exemption, it should not be viewed as a total solution to health care for the uninsured poor.  Standing alone, a charity care system administered at the hospital level virtually assures that the uninsured will not engage in much, if any, preventive care, and instead will wait until a serious illness compels hospitalization which then would be “free” under this system.[22]  This behavior would be exactly contrary to the emphasis put on preventive care by most (if not all) health policy experts.  Certainly, having more charity care is better than having less, but it is not a complete solution to health care for the uninsured.

B.  Replacing Community Benefit with a More Accountable Standard

A second possibility is to replace the community benefit standard with something more flexible than the strict charity care approach, but which has more specific behavioral guidelines that would provide more accountability than the community benefit standard.  For example, the Catholic Hospital Association once promulgated guidelines for its members limiting “community benefits” to behavior that would not duplicated by the for-profit sector.[23]  Another approach along these lines is my recent suggestion that we require exempt hospitals to focus on a mission of “enhancing access.”[24]  This test would permit exemption when individual health care entities develop a specific plan for enhancing access to services and demonstrate actual financial commitment to and execution of such a plan.  “Enhancing access” would encompass not just free or expanded care for the poor, but could also involve providing usual health services to a medically-underserved population (e.g., an HMO formed to bring health services to a medically-underserved area) or providing services to the general population that were previously unavailable or under-provided.  Thus a particular entity that formulated a plan to provide expanded AIDS treatment (a service identified in empirical work as unprofitable and hence under-provided) and met minimum financial commitments to such treatment might be rewarded with exemption.  The downside of this approach is that it provides less clarity and therefore less stringent accountability than a strict charity care standard.  In effect it introduces some “fuzziness” as compared to a strict charity care standard in order to achieve more flexibility.

C.   Repeal the Community Benefit Standard

The final possibility would be to repeal the community benefit test.  Under this alternative, a few hospitals that met other traditional standards of charity could remain exempt – for example, academic medical centers would remain exempt as an educational institutions under Code Section 501(c)(3); and a few organizations such as the Mayo Clinic might be able to make the case that they are primarily engaged in medical (scientific) research and hence would be exempt for that purpose.  Similarly, a clinic whose primary purpose was to serve the poor would be exempt as a poor relief charity.  Most private nonprofit hospitals, however, would lose exemption under this approach, because their primary purpose would not be education, research or poor relief (rather, their primary purpose is to provide health services for a fee), but that is not necessarily a bad thing. A number of commentators argue that our health care system would be better served by taking the money saved from tax exemption and using it for entity-neutral, direct financial incentives for certain behavior.[25]  For example, if the problem is health care access for the uninsured poor, the system might be better off eliminating exemption and taking the revenues resulting from that decision to expand Medicaid.  Or if we believe there is a problem of access to unprofitable services, we could use the money to provide direct incentives to all hospitals to provide more such services.

Of course, the downside of such entity-neutral incentives is that such incentives would be complicated to enact and administer, requiring agreement by Congress or a duly-delegated agency on the exact policy initiatives that this approach would subsidize.  Because of the need for national political agreement, the direct incentives approach in the long run may be less desirable than an approach focused on more specific local community needs – for example, a particular community might need charity care more than it needs a burn unit.

Summary

One of the hardest things for human beings to do is to let go of the past.  Prior to WWII, hospitals were essentially homeless shelters for the poor, often run by religious orders and staffed with volunteers.  Today they are multi-million or in many cases multi-billion-dollar fee-for-service businesses.  The reasons that justified exemption for hospitals in 1928 simply don’t exist any more, and I think that this Committee should carefully reconsider whether multi-billion-dollar fee-for-service businesses should be eligible for tax exemption at all.  At the very least, shouldn’t we replace community benefit with some specific behavioral standard that will provide accountability and enable us to answer with certainty the question posed earlier, “What are we getting for our money?”