Overview of the Tax Treatment of Nonprofit Hospitals and Their For-Profit Subsidiaries: A Short-Sighted View Could Be Very Bad Medicine Comment

Pace Law Review Volume 15 Issue 2 Winter 1995 Article 4 January 1995 Overview of the Tax Treatment of Nonprofit Hospitals and Their For-Profit Subsidiaries: A Short-Sighted View Could Be Very Bad Medicine Comment Andrea I. Castro Follow this and additional works at: https://digitalcommons.pace.edu/plr Recommended Citation Andrea I. Castro, Overview of the Tax Treatment of Nonprofit Hospitals and Their For-Profit Subsidiaries: A Short-Sighted View Could Be Very Bad Medicine Comment, 15 Pace L. Rev. 501 (1995) Available at: https://digitalcommons.pace.edu/plr/vol15/iss2/4 This Article is brought to you for free and open access by the School of Law at DigitalCommons@Pace. It has been accepted for inclusion in Pace Law Review by an authorized administrator of DigitalCommons@Pace. For more information, please contact . Comment Overview of the Tax Treatment of Nonprofit Hospitals and Their For-Profit Subsidiaries: A Short-Sighted View Could Be Very Bad Medicine I. Introduction Nonprofit hospitals have recently found themselves between the proverbial rock and hard place. These tax-exempt health care entities are subject to the vagaries of the federal and state governmental agencies which, through legislative grace, bestow favorable tax treatment on them.' Until recently, the nonprofit hospital sector existed in a tolerant environment where only the most egregious conduct would cause the loss of 2 tax-exempt status. Lately, however, that tolerance has shifted to stricter scrutiny at both the federal and state levels, often resulting in revocation of exempt status under circumstances that would not have occurred in the past.3 Much of the changed attitude has 1. 26 U.S.C. § 501(c)(3) (1988 & Supp. V 1993). This section of the Internal Revenue Code grants federal tax exemption to nonprofit hospitals based upon a determination that nonprofit hospitals serve a charitable purpose. See infra note 21 and text accompanying note 35. Although the Internal Revenue Code ("the Code" or "I.R.C.") is codified at 26 U.S.C., it will hereinafter be referred to by its I.R.C. designation alone (for example I.R.C. § 501(c)(3)), as this is the common way that the Code is referenced in tax materials and by practitioners. See also Mark A. Hall & John D. Colombo, The CharitableStatus of Nonprofit Hospitals: Toward a Donative Theory of Tax Exemption, 66 WASH. L. REV. 307, 310-13 (1991) (examining the origin of the charitable exemption). 2. See John D. Colombo & Mark A. Hall, The Future of Tax-Exemption for Nonprofit Hospitals and Other Health Care Providers, 6 ExEMPT ORG. TAX REV. 395, 396-99 (Mar. 1993). 3. Id. 1 PACE LAW REVIEW [Vol. 15:501 been attributed to the increased commercial activity4 that hospitals have undertaken. 5 These hospitals have been criticized for allegedly redirecting their focus away from their exempt purpose of health care, to that of a commercial entity. In so doing, it is argued that they have come to differ little from their for-profit counterparts s and accordingly, deserve no favorable tax treatment. 7 The nonprofit hospitals, on the other hand, contend that they must engage in joint ventures with physicians, and other revenue raising activities, in addition to their primary focus on health care, merely to survive. 8 They counter that economic conditions have strained their traditional revenue sources to the point that these sources no longer cover the litany of costs to which they are subject. 9 Thus, they must find other avenues in order to raise income. 10 They stress, however, that their primary mission is still unquestionably charitable and, thus, deserving of exempt recognition, irrespective of the commercial ventures in which they are engaged." The responses on the federal and state levels to this nonprofit commercial activity have been to examine exempt hospitals more closely.' 2 For example, the Internal Revenue 4. See discussion infra part I.C. 5. See Edward Skloot, Enterprise and Commerce in Nonprofit Organizations, in THE NONPROFIT SECTOR: A RESEARCH HANDBOOK 380, 380 (Walter W. Powell ed., 1987). 6. For-profit hospitals, like all for-profit enterprises, have an ultimate purpose of earning profits for their shareholders. Walter W. Powell & Rebecca Friedkin, OrganizationalChange in Nonprofit Organizations,in THE NONPROFIT SECTOR: A RESEARCH HANDBOOK 180, 180 (Walter W. Powell ed., 1987). See also infra text accompanying notes 225-28 for a further discussion on the differences between the services delivered by nonprofit and for-profit hospitals. 7. See generally G.J. Simon, Jr., Comment, Non-Profit Hospital Tax Exemptions: Where Did They Come From and Where Are They Going?, 31 DuQ. L. REV. 343, 343 (1993) (questioning the continued validity of exempt status). 8. See infra notes 86-88 and accompanying text. 9. See PAUL STARR, THE SOCIAL TRANSFORMATION OF AMERICAN MEDICINE 160 (1982) (discussing the change in hospital financing from the 19th to the 20th century). 10. Id. at 161-63. 11. J. David Seay, Tax-Exemption for Hospitals:Towards an Understanding of Community Benefit, 7 EXEMPT ORG. TAx REV. 413, 414 (Mar. 1993). 12. See discussion infra parts II.A and III.B. https://digitalcommons.pace.edu/plr/vol15/iss2/4 2 1995] NONPROFITHOSPITALS 503 Service' 3 ("the Service") has raised the level of scrutiny in audits of taxable subsidiaries, replacing the former practice of using one auditor to review all aspects of a nonprofit hospital organization, with a team of agents. 14 The purpose of this action being that as involvement with for-profit enterprises increases, the nonprofit hospitals lose their traditional charitable mission. Hence, the Service has reasoned, this arguable change in focus makes nonprofit hospital organizations with many forprofit subsidiaries virtually indistinguishable from their forprofit hospital counterparts. Consequently, it calls into question their traditional justification for receiving favorable tax status.15 Additionally, the state and federal governments have developed two distinct, and seemingly incompatible criteria for maintaining or receiving exemption, sending the nonprofit hospital industry into turmoil. 16 Thus, the nonprofit hospitals must choose whether to continue the activity that will raise commercial revenue and lose the exemption at one governmental level, but maintain it at the other; or meet both standards by virtually ceasing commercial activity, thereby risking their ability to survive. This Comment presents an examination of the state and federal taxation consequences faced by nonprofit hospitals, which own for-profit subsidiaries. Part II reviews the history of the nonprofit hospital sector from its inception as a purely charitable, health-care entity, through events that led to diversification of the market, including the acquisition and formation of taxable subsidiary enterprises. Part III explores the taxation treatment that nonprofit hospitals have received at the federal, state and local l (...truncated)