Grey Area Anatomy: Tax Exemptions for Nonprofit Hospitals

I.  Introduction

A key battle over America’s healthcare future is being fought in one of the most unlikeliest of places: Urbana, Illinois.  Scheduled for argument in front of the Illinois Supreme Court in mid-2009, Provena Covenant Medical Center v. Department of Revenue is poised to set the bar regarding the tax exempt status of nonprofit hospitals.[1] Nonprofit hospitals, such as Provena, account for near sixty percent of the hospitals in the U.S., while the others are either for-profit or government-owned.[2] Oddly, these nonprofit hospitals are actually faring better than their for-profit counterparts. Seventy-seven percent of the 2033 U.S. nonprofit hospitals are “in the black”, while sixty-one percent of for-profit hospitals are profitable.[3] One of the reasons for such high success rates is the ability of non-profit hospitals to receive significant tax exemptions. The Congressional Budget Office reported in 2006 that nonprofit hospitals receive an estimated $12.6 billion in annual tax exemptions on top of the $32 billion in federal, state and local subsidies the hospital industry receives each year.[4] Given such figures, it is not surprising that many hospitals do not make up for the exemptions they receive with the charitable services they provide.  This article delves into the federal income tax code applications for nonprofit hospitals and resulting litigation.

For an organization to receive federal income tax exemptions it must be both organized as a nonprofit entity and meet certain operational standards.  As dictated by section 501(c)(3) of the Internal Revenue Code (I.R.C), certain organizations, such as schools and religious entities, are enumerated as being exempt from federal income tax.[5]  Those that are not enumerated must have a charitable purpose, as dictated by certain standards within the code.  This analysis of charitable purpose falls under the categories of Organizational Requirements and Operational Requirements.  For Organizational Requirement to be satisfied, the non-enumerated entity cannot further non-charitable purposes. Operational Requirements examine the manner in which charitable care is delivered.[6]

II.  The Federal Code

The code dictates that a tax-exempt entity must be established exclusively for charitable purposes, yet courts have not strictly followed this language.[7] A number of different principles have arisen to test the charitable nature of such so-called charitable purposes.  
The Commerciality Doctrine examines the services provided, looking at whether they are performed for a profit.[8] Largely fact-specific, the Commerciality Doctrine is based upon the profitable nature of the activity,[9] the magnitude of the activity in relation to the organization's other exempt activities,[10] how the activity supports or furthers the exempt purpose(s) of the organization,[11] whether the activity is one that is ordinarily conducted by for-profit entities,[12] and the business and marketing practices employed in conducting the activity.[13] Inconsistent in its application and outcome, the Commerciality Doctrine was utilized in the famous Trinidad opinion, which spurred the Destination-of-Income Test.[14] The Destination-of-Income Test from Trinidad v. Sagrada Orden de Predicadores focused upon how a funding source is irrelevant as long as the money goes towards the establishment of charitable purposes. The Destination Test was largely utilized until 1954, when I.R.C. section 502 changed the perspective of the Internal Revenue Service (IRS).  The Commerciality Doctrine today disregards the final resting place of funds and examines the manner of the organization.  An organization that does not engage “primarily in activities which accomplish one or more of such exempt purposes specified in section 501(c)(3)” does not qualify for federal income tax exemption.[15] While organizations are required to carry the burden of proof in determining their tax-exempt standard, hospitals have essentially written themselves in as a per-se charitable organization, almost rising to the enumerated classification of churches and schools.

III. Debate

While there are policy rationales for giving hospitals tax-exempt status, such as the promotion of scientific innovation and indigent care, the question of how “charitable” many hospitals actually are has spurred significant debate.[16]  Revenue Ruling 56-185 set the standard as to whether or not hospitals should receive exemptions for their charitable care, allowing the exemptions as long as hospitals performed charitable activities to the extent that their finances allowed.[17]  Revenue Ruling 69-545 modified Revenue Ruling 56-185 and introduced the “community benefit” standard.[18]  Under the community benefit standard, a hospital can maintain its exempt status by operating for the benefit of the community “as a whole.”[19]  Revenue Ruling 83-157 further modified Revenue Ruling 69-545, removing emergency room care from the community benefit standard.[20] This hodge-podge of subjective standards and exceptions to the code is what is employed today, making the overall policy very murky.

While legislative actions have been taken in an attempt to make hospitals I.R.C.-enumerated exemptions, differing political factions have largely thwarted such efforts.[21] Judicially, patients, like those in E. Ky. Welfare Rights Org. v. Schultz, have taken actions claiming that the I.R.S. had “acted unlawfully in approving tax exemptions for hospitals without regard to their provision of care for the indigent.”[22]  Although the district court held for the plaintiffs Schultz, the D.C. Circuit Court of Appeals reversed the ruling, finding that the I.R.S.'s interpretation was “not contrary to any express Congressional intent.”[23] [24] The Schultz case was dismissed by the Supreme Court for lack of standing, and the Sixth Circuit also rejected a similar claim in Lugo v. Miller.[25]  In 2004, litigation surrounding hospital exemptions began anew, proceeding on the theory that tax-exempt hospitals had breached their fiduciary duty under I.R.C. section 501(c)(3) to act on behalf of the public.[26]  Largely unsuccessful, these claims have failed because the courts have held that I.R.C. section 501(c)(3) does not permit a private right of action against organizations for failure to fulfill their charitable mandates.[27]  

IV. Provena

The Provena case has garnered national attention, as it pits a local governing body against hospital interests.  Claiming that its purposes are charitable, and that it is a healthcare ministry of the Roman Catholic Church, Provena Covenant protested the $1.1 million in property taxes that was required by Champaign County.[28]  Focusing upon the charitable purpose claim, the appellate court noted that Covenant devoted only 0.7% of its total revenue to charity.[29] Interestingly, such figures are not particularly unusual; even those hospitals that are the most charitable put in less than fifteen percent of their revenue towards charity.[30] Echoing an argument made throughout the nation, Provena pointed out the difficulties and meager payment rates of Medicare and Medicaid.[31] The court outlined the necessity for Provena to prove “clearly and conclusively” that it was entitled to the exemptions[32], and that the revenue director had to revolve the ambiguous points in the law to be in favor of taxation.[33] Furthermore, the court approached the issue of charitable tax exemption by noting that there are both statutory and state constitutional requirements for the exemptions.[34]  Applying standards from Methodist Old Peoples Home v. Korzen, the court established six distinctive characteristics of a charitable institution: (1) the institution gives benefits upon an indefinite number of people for their welfare, or reduces said individuals dependence on the government; (2) the organization has no shareholders or capital structure; (3) the funds come from charitable gifts; (4) charity is dispensed to all who need it and apply for it; (5) the institution puts no obstacles to those seeking the charity; and (6) the primary use of the property is for charity.[35] Overall, Provena argues that it is a charitable organization because they provide the community with the invaluable service of health care.[36] The appellate court did not agree, saying that “[b]y holding medical care to be, in and of itself, charity, we effectively would excuse charitable hospitals from their ongoing mission of giving.”[37]

IV.  Conclusion

Regardless of how charitable functions are defined by individual states, the conflicts between non-profit hospitals and revenue departments are likely to be convoluted and extensive. By examining the code structure surrounding hospital tax-exemptions, and the litigation that has arisen in the path of such tax-exemptions, cases such as Provena can be understood more thoroughly.  While hospitals are to serve the communities where they are located, to what degree such service is charitable is the focal point of the ongoing debate, and why events in small towns, such as Urbana, Illinois command national attention.[38]

[1] Provena Covenant Med. Ctr. v. Dep’t. of Revenue, 384 Ill. App. 3d 734 (App. Ct. 2008).  

[2] John Carreyrou, Nonprofit Hospitals, Once For the Poor, Strike It Rich, WALL ST. J., Apr. 4, 2008,

[3] Id.

[4] Id.

[5] I.R.C § 501(c)(3) (2000).

[6] Terri L. Brooks, Billions Saved In Taxes While Millions Underserved – What Has Happened to Charitable Hospitals?, 8 Hous. Bus. & Tax L.J. 391, 396 (2008).

[7] Id.  
[8] Bradley Myers, Revisiting the Commerciality Doctrine, 10 J. Affordable Housing & Cmty Dev. L. 134, 138 (2001).

[9] See Scripture Press Found. v. United States, 285 F.2d 800 (Ct. Cl. 1961); B.S.W. Group, Inc. v. Comm’r, 70 T.C. 352, 358 (1978).

[10] Scripture Press Found., 285 F.2d at 805-06.

[11] See S.F. Infant Sch., Inc. v. Comm’r, 69 T.C. 957, 966 (1978).

[12] B.S.W. Group, Inc., 70 T.C. at 358.

[13] W. Marshall Sanders, The Commerciality Doctrine is Alive and Well, 16 Tax’n of Exempts 209, 210 (2005).

[14] Fides Publishers Ass’n v. United States, 263 F. Supp. 924, 935 (N.D. Ind. 1967).

[15] Treas. Reg. § 1.501(c)(3)-1(a)(1) (1959).

[16] See Daniel M. Fox & Danile C. Schaffer, Tax Amdinistration as Health Policy: Hospitals, the Internal Revenue Services and the Courts, 16 J. Health Pol. Pol’y & L. 251, 255-56 (1991); Rev. Rul. 69-545, 1969-2 C.B. 117 (citing Restatement (Second) of Trusts § 368 and § 372 (1959)); Rosemary Stevens, In Sickness and in Wealth 17-51 (Basic Books 1989).    

[17] Douglas M. Mancino, Income Tax Exemption of the Contemporary Nonprofit Hospital, 32 St. Louis U. L.J. 1015, 1040 (1988).  

[18] John D. Colombo, The Role of Tax Exemption in a Competitive Health Care Market, 31 J. Health Pol. Pol’y & L. 623, 625 (2006).

[19] Id.

[20] See Rev. Rul. 69-545.

[21] Rev. Rul. 83-157, 1983-2 C.B. 93-95.  

[22] See I.R.C. § 501(c)(3) (2000).

[23] E. Ky. Welfare Rights Org. v. Schultz, 370 F. Supp. 325, 326 (D.D.C. 1973).

[24] E. Ky. Welfare Rights Org. v. Simon, 507 F.2d 1278, 1290 (D.C. Cir. 1974).
[25] Lugo v. Miller, 640 F.2d 823, 831 (6th Cir. 1981).

[26] Beverly Cohen, The Controversy over Hosptial Charges to the Uninsured – No Heroes, No Villains, 51 Vill. L. Rev. 95, 98-103 (2006).  

[27] McCoy v. E. Tex. Med. Ctr. Reg’l Healthcare Sys., 388 F. Supp. 2d 760, 769-70 (E.D. Tex. 2005).

[28] Provena Covenant Med. Ctr. v. Dep’t. of Revenue, 384 Ill. App. 3d at 736.

[29] Id. at 737.

[30] Carreyrou, supra note 2.

[31] Provena Covenant Medical Ctr., 384 Ill. App at 737.

[32] Illini Media Co. v. Dep’t. of Revenue, 279 Ill. App. 3d 432, 435 (App. Ct. 1996).  

[33] Id.

[34] Provena Covenant Med. Ctr., 384 Ill. App at 740-741.

[35] S.H.A. 35 ILCS 200/15-65(a); Provena at 742.

[36] Crerar v. Williams, 145 Ill. 625, 643 (1893).

[37] Provena Covenant Med. Ctr. at 748.

[38] School of Domestic Arts & Science v. Carr, 322 Ill. 562, 569 (1926).