Beyond Saber Rattling Congress Threatens Aggressive Regulation Of Nonprofits, Health Care Providers

Last summer saw three converging events which have raised storm flags for tax-exempt health care providers: multiple class action lawsuits against targeted health care systems alleging insufficient indigent care and overly aggressive bill collection practices; a new IRS examination program on nonprofit executive compensation; and serious congressional consideration of legislative ‘reforms’ to correct publicized and perceived excesses by exempt entities.

 

Perhaps the most stunning of these developments is the sudden sharp interest of the U.S. Senate in nearly every aspect of nonprofit activity. Although it is likely that any legislative proposals will not be considered until next year, and even if passed will be substantially modified from early discussion drafts, the current proposals are breathtaking in their reach and suggest that Congress is serious about substantially regulating the operations and governance of nonprofit organizations, including health care providers.

In preparation for the Senate Finance Committee hearings on nonprofit organizations held in June, committee staff developed several proposals, the most noteworthy of which are summarized below. The proposals can be broken down into four areas affecting exempt providers: operations, governance, additional tax filing requirements, and enforcement.

Proposals Affecting Operations

Without much explanation, the committee staff proposal would abolish all supporting organizations (referred to as Section 509(a)(3) organizations).

ranslated, this could effectively preclude the continued tax-exempt operation of most parent organizations, certain foundations, and other ancillary organizations in multi-corporate health care delivery systems.

Staff also proposed to apply the private foundation excise tax rules to public charities. In essence, this would extend the excise taxes in the current intermediate sanctions provisions (payable primarily by the offending disqualified person) to the organization itself. The rebuttable presumption as to the reasonableness of compensation and the ability to rely on an expert opinion to establish reasonableness would also be restricted (or possibly eliminated). Amounts paid to reimburse directors and management for travel and lodging would be capped at the federal rate, with any excess subject to penalties and disgorgement.

Conversions of exempt entities to for-profit status (for example, in the Blue Cross context) would no longer be subject just to state regulation; the proposal would establish a ‘one-two punch’ of new state and federal remedies. Federal standards for both state and federal review of these transactions to ensure protection of the public interest would be authorized.

Much like a Hart-Scott-Rodino filing, advance federal notice of the transaction would be required. The provision would vest the IRS with the same powers as state attorneys general to participate in administrative proceedings to review the transaction and to protect charitable assets, and both levels of government would be able to participate in the other’s proceedings. Conversion ultimately would be conditioned on IRS approval, and any built-in gain recognized on the conversion would be taxed at the highest corporate rate.

Governance ‘Reforms’

This proposal would pick up where Sarbanes-Oxley left off, with renewed vigor. First, a federal cause of action would be created for the breach of a director’s fiduciary duty. (Imagine the potential impact on the organization’s ability to recruit directors or on the cost of D&O premiums.)

Compensation for all senior management must be approved by the board of directors in advance. A host of federally created duties would also be imposed: the board would be required to approve the budget, the entity’s programs, a conflict of interest policy, the adoption of a compliance plan, and provisions to protect whistleblowers.

Although many of these are now undertaken by exempt health care providers as a matter of fiduciary duty or as a matter of good governance, these board responsibilities now will be federally mandated. Entities complying with these ‘good governance’ dictates would be favored in the award of government contracts (although whether these will be required for Medicare participation is yet to be seen). Compliance must be documented on the IRS Form 990. In perhaps one of the most ‘big brother-ish’ of the provisions, the actual board size of the entity would be regulated: at least three but no more than fifteen directors. Finally, like attorneys general in some states, the proposal would give the IRS the power to both remove errant directors and forbid them from serving on other exempt entities for some future period.

New Filing Requirements

The proposal contains at least four new filing requirements for tax-exempt organizations. They appear modest — but only in comparison to the overreaching provisions affecting operations and governance discussed above. First, exemption would have to be re-established every five years (in a process much like that for filing the original Form 1023). In addition to providing evidence that the entity continues to be organized and operated for exempt purposes, the entity would have to provide evidence of the governance practices described above. A filing fee, based on the entity’s size, would be imposed to enable the IRS to conduct the review. As to the Form 990 itself, a new provision would be added similar in nature to the certifications required of executives under the Sarbanes-Oxley Act.

The entity’s CEO would have to execute a declaration under penalty of perjury that there are in place policies and procedures to ensure that the return complies with the Internal Revenue Code. Form 990s would have to be reviewed by an independent auditor to ensure completeness and accuracy, and the auditor’s report would have to be attached. Health care providers, because of their size, also would be required to have an audit of their financials. Finally, the Form 990 would have to include a ‘table of organization’ showing all affiliates of the provider, would have to report any insider transactions, and would have to disclose all ancillary joint ventures and partnerships. Various tax and other opinions also would have to be attached.

Implementation

The proposal both contains additional judicial enforcement remedies and provides for increased funding to the IRS to perform these new responsibilities. As to the latter, funding would come from increased filing fees for Form 990s and the five-year re-determination application. In addition, funds would be appropriated for state enforcement and oversight of exempt entities, and to fund organizations that both educate exempt organizations on ‘best practices’ and will ‘accredit’ such organizations’ compliance with such practices.

The second enforcement remedy comes through the courts. The Tax Court would be given equitable powers to rescind transactions, penalize directors financially, remove directors, and appoint substitutes. State actions pursuing the same remedies would postpone, but not collaterally stop, Tax Court jurisdiction. In addition (and coupled with funding for an IRS exempt organization violation ‘hotline’), the proposal would establish federal private rights of action by directors to compel or otherwise challenge actions by exempt organizations inconsistent with their nonprofit, tax-exempt status, and by qui tam relators. In both cases, successful complainants could have their attorneys fees paid.

Obviously, most of these legislative proposals are vastly overreaching and duplicative of existing rights, remedies, and requirements. Nonetheless, they signal Congress’ determination to eradicate perceived abuses in the exempt organization arena through increased scrutiny and regulation of exempt entities — in many cases going beyond the Sarbanes-Oxley requirements for public companies. These developments should be carefully monitored, and participation in legislative committee hearings and lobbying regarding these issues should be a priority for the exempt provider community.

Thomas K. Hyatt and Patrick K. O’Hare practice in Health Law with Ober/Kaler Attorneys at Law. They are co-chairs of the firm’s Nonprofits Group. Hyatt can be reached at (202)326-5039 or tkhyatt @ober.com, and O’Hare can be reached at (202)326-5077 or pkohare@ober.com.