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ABA Health eSource
 April 2005 Volume 1 Number 8

Overview of Charity Care Requirements
Imposed Upon Nonprofit Hospitals

by David M. Flynn, Duane Morris L.L.P, Philadelphia, PA

David M. Nelson

Nonprofit, tax-exempt hospitals have been faced for many years with questions regarding to need to provide appropriate levels of “charity care” to the communities they serve. The requirements derive from several sources, and the parameters establishing legal minimums are neither clearly-defined nor uniform. The financial accounting rules for classification of services to be treated as “charity care” may be somewhat easier to articulate (if not to apply), but they may not accurately mirror the various legal requirements.

Recent class action lawsuits filed against nonprofit hospitals throughout the country, and recent actions by attorneys general in various states, have served to heighten the focus and interest placed upon the establishment, implementation and adherence to appropriate “charity care” policies on the part of nonprofit hospitals. In addition, comments made during the past year by the Chair of the Senate Finance Committee and the Chair of the House Ways & Means Committee have also increased the focus on the requirements for nonprofit hospitals to qualify for federal income tax exempt status.

“Charity Care” Requirements under the Federal Tax Law

No Clear Requirement

Under current IRS published precedential authority, the only clear requirement that applies for charitable tax-exempt status is that a hospital must operate a full-time emergency room providing treatment to all patients presenting themselves for service without regard to their ability to pay. Current law (and the IRS position) does not specify a minimum level of free or charity care that must be provided to indigent patients by an acute-care hospital in order to qualify for federal income tax exemption under section 501(c)(3) of the Internal Revenue Code. There is also no clear definition of what qualifies as charity care, nor any specific guidance concerning how to identify statistically or otherwise the individuals in a relevant community who can be classified as members of an appropriate charitable class for purposes for classifying free or below cost care as charity care.

The “Financial Ability” Standard

Nonprofit hospitals qualify for federal income tax exempt status under section 501(c)(3) provided they are organized and operated exclusively for charitable, scientific, or educational purposes. “Charitable” is not defined in the Code. The regulations define the term to include specifically relief of the poor and distressed or the underprivileged, but they do not require such relief as an indispensable condition for tax-exempt status. Foot NoteThe regulations provide that the term is used in its generally accepted legal sense, and includes lessening the burdens of government, advancing education or science, and promoting social welfare.

Approximately three years before the final section 501(c)(3) regulations were adopted, Rev. Rul. 56-185 (1956-1 C.B. 202) was published by the IRS. In it, the IRS listed four requirements that a hospital was required to meet in order to qualify under section 501(c)(3). Only two of those four requirements were in addition to the requirements already prescribed in the statute. The first of these was that a hospital must be operated to the extent of its “financial ability” for those not able to pay for the services rendered, and not exclusively for those who are able and expected to pay. The second was that a hospital must not restrict the use of its facilities to any particular group of physicians and surgeons (to the exclusion of all other qualified physicians).

The “financial ability” standard was somewhat flexible. Rev. Rul. 56-185 expressly provided that a particular hospital’s inadequate record in providing charity care was not conclusive in showing a failure to meet the standard. Such a hospital alternatively could furnish services at reduced rates that were below cost and count that as charity care rendered, and also could set aside earnings that it planned to use for future improvements and additions to its hospital facilities. On the other hand, the financial ability standard would not permit a hospital to refuse to accept patients in need of care who are unable to pay for services rendered, and would not permit classification as charity care the failure of some patients to pay for services rendered by a hospital that operated with the expectation of full payment from all those to whom it rendered services.

The “Community Benefit” Standard

The “community benefit” standard came into existence with the publication by the IRS of Rev. Rul. 69-545 (1969-2 C.B. 117), which expressly modified Rev. Rul. 56-185 to eliminate the financial ability requirement. The basic rationale of Rev. Rul. 69-545 was that a tax-exempt hospital must be organized and operated exclusively to further a purpose considered to be “charitable” in the generally accepted legal sense, and not for the benefit of private interests, and that in the general law of charity the promotion of health is considered to be such a purpose. The IRS reasoned that a hospital that provides hospital care on a nonprofit basis for members of its community is organized and operated in furtherance of a purpose considered charitable in the generally accepted legal sense of that term, and noted that the promotion of heath, like the relief of poverty and the advancement of education and religion, is one of the purposes in the general law of charity that is deemed beneficial to the community as a whole, even though the class of beneficiaries eligible to receive a direct benefit from its activities does not include all members of the community, such as indigent members of the community, provided that the class is not so small that its relief is not of benefit to the community.

The IRS concluded that by operating an emergency room open to all persons without regard to ability to pay and by providing hospital care for all those persons in the community able to pay the cost of that care either directly or through third-party reimbursement, a hospital is promoting the health of a class of persons that is broad enough to benefit the community. Other important (but not in any particular case essential) factors identified as favorable factors supporting qualification for charitable, section 501(c)(3) status were: (1) a board of directors drawn from the community, (2) an open medical staff policy, (3) treatment of patients paying their bills with the aid of public programs such as Medicare and Medicaid, and (4) the application of surplus to improving facilities, equipment, patient care, and medical training, education, and research.

The community benefit standard adopted in Rev. Rul. 69-545 was amplified in Rev. Rul. 83-157 (1983-2 C.B. 94) which involved a nonprofit hospital that did not operate an emergency room. In that ruling the IRS held that the community benefit standard had been satisfied by reference to some of the other factors identified above, and held that the operation of an emergency room was not critical in all cases (in Rev. Rul. 83-157, a state health planning agency had determined that an emergency room was unnecessary because it would duplicate emergency services and facilities already adequately provided by another hospital in the community).

The validity of Rev. Rul. 69-545 and its community benefit standard as a replacement for the financial ability standard of Rev. Rul. 56-185 was upheld by the United States Court of Appeals for the District of Columbia in 1974. Foot NoteThe Circuit Court rejected the argument that a nonprofit hospital should be required to provide free or below-cost care to those unable to pay as a condition to qualification under section 501(c)(3).

Subsequent Developments

Legislative efforts were made in 1990 and in 1991 to establish minimum levels of charity care that a hospital would have to satisfy in order to qualify for section 501(c)(3) status Foot Note(accompanied by a General Accounting Office report concerning nonprofit hospitals) Foot Note. None of these efforts resulted in enactment of a minimum charity care standard.

Finally, much more recently, in litigation concerning the tax-exempt status of the St. David’s Health Care System Foot Notethe government appeared to take a charity care position quite different from the community benefit standard in spite of what appear to have been fairly clear developments relating specifically to the elimination of the financial ability standard of Rev. Rul. 56-185 by Rev. Rul. 69-545. The IRS (or someone in the federal government) apparently continues to believe in the existence of a minimum charity care requirement for tax-exempt status, and clearly incorporated that position into arguments made in support of the government’s motion for summary judgment in the St. David’s case. These positions suggest clearly the view that satisfaction of the requirements of the community benefit standard as set forth in Rev. Rul. 69-545 is not alone sufficient for qualification for tax-exemption as a charitable organization under section 501(c)(3). In addition to satisfying those requirements, the provision of an unspecified minimum level of charity care was said to be required in order for a hospital or other healthcare provider to so qualify.

Perhaps this position, taken in litigation, is of no more significance than a frequently-cited Field Service Advice (FSA 200110030) in which the IRS Chief Counsel’s Office responded to a request from an IRS Area Counsel for interim guidance on the legal criteria for hospitals to qualify for exemption under section 501(c)(3). In the FSA it was stated that the provision of free or subsidized care to the indigent is a significant indicator to the courts and the IRS that a hospital promotes health for the benefit of the community. Thus, although the FSA suggests the existence of a minimum “charity care” requirement, it cites no legal authority supporting the existence of such a requirement, and appears, on careful analysis, to support instead the conclusion that an open emergency room is sufficient to satisfy the requirements of the community benefit standard.

Depending upon the mood and priorities in the Congress, the current status quo may change. It seems unlikely, however, that an administrative change in position is in the offing.

State Law “Charity Care” Standards

Variations in Standards

Under state law, charity care requirements can be important for income tax-exempt status, real property tax-exempt status and sales tax-exempt status. The standards generally vary, often significantly, from state to state, and even the standards within a single state for different kinds of tax-exempt status can differ.

In many states exemption from corporate income tax will apply based solely upon qualification for federal income tax-exempt status, with no separate state law requirements. In other states (for example, California), separate applications for income tax-exempt status must be submitted and approved by the taxing authority.

It is important to note that in the case of many nonprofit hospitals, exemption from state and local real property taxes may be of greater significance financially than exemption from federal and state income taxes.

The Situation in Pennsylvania

One example of the existence of different standards for different tax purposes is the Commonwealth of Pennsylvania. Pennsylvania income tax-exempt status follows federal income tax-exempt status, so that a hospital that qualifies as an organization described in section 501(c)(3) of the Internal Revenue Code will also be exempt from Pennsylvania’s corporate net income tax and its capital stock tax. Completely different standards apply, however, for exemption from sales and use tax and exemption from real property taxes.

Sales and use tax in Pennsylvania is generally governed by the same rules that apply for real estate tax-exempt status, but determinations concerning exemption from these taxes are jurisdictionally different. Sales and use tax exemptions customarily are obtained by application to the Pennsylvania Department of Revenue, and generally enjoy a 5-year term before reapplication is necessary. Although there is rebuttable presumption that a hospital that qualifies for sales and use tax exemption in Pennsylvania will also qualify for real property tax-exempt status in the Commonwealth, real property tax-exempt status is generally determined at the county level, and determinations at the county level may be appealed by local school districts and/or by local townships or municipalities.

The Pennsylvania Constitution permits tax exemption for “institutions of purely public charity.” Foot NoteIn this regard, the Pennsylvania Legislature has enacted an “institutions of purely public charity act” (10 P.S. §371, et seq) in which it establishes certain criteria for qualification as an institution of purely public charity (10 P.S. §375). The statutory provisions were enacted in an attempt, essentially, to codify the interpretation by the Supreme Court of Pennsylvania of this provision in the Pennsylvania Constitution in Hospital Utilization Project v. Commonwealth, 487 A.2d 1306 (Pa. 1985) in which the Supreme Court established the following test:

“[A]n entity qualifies as a purely public charity if it possesses the following characteristics.

(a) Advances a charitable purpose;

(b) Donates or renders gratuitously a substantial portion of its services;

(c) Benefits a substantial and indefinite class of persons who are legitimate subjects of charity;

(d) Relieves the government of some of its burden; and

(e) Operates entirely free from private profit motive.” 487 A.2d, at 1317.

One criterion requires that such an institution “advance a charitable purpose.” This criterion is satisfied if the institution is organized and operated primarily to fulfill any one of several purposes, including the relief of poverty, and the prevention and treatment of disease or injury, including mental retardation and mental disorders.

Another criterion more directly relevant to the provision of charity care requires that the institution must “donate or render gratuitously a substantially portion of its services.” Satisfaction of this requirement (in 10 P.S. §375(d)(1)) can be established through the application of several quantitative tests. Essentially, the statute provides a menu of alternatives, some of which are more likely to be applicable to hospitals, while others might more likely apply to educational institutions or to other types of nonprofit organizations.

Under one approach, an institution that has a written policy to provide services to all who seek them without regard to their ability to pay, and has published this policy in a reasonable manner, can satisfy this requirement if it provides uncompensated goods or services at least equal to 75% of the institution’s net operating income but not less than 3% of the institution’s total operating expenses. Under another approach, goods or services for fees that are based upon the recipient’s ability to pay would permit qualification provided the institution can demonstrate that it has implemented a written policy and a written schedule of fees based on individual or family income, that at least 20% of the individuals receiving goods or services pay no fee or a fee that is lower than the cost of the goods or services, at least 10% of the individuals receiving goods or services receive a reduction in fees of at least 10% of the cost of the goods or services, and no individuals receiving goods or services pay a fee that is equal to or greater than the cost of the goods or services provided. Another approach is for an institution to provide wholly gratuitous goods or services to at least 5% of those receiving similar goods or services from the institution. Yet another alternative is the provision of uncompensated goods or services which in the aggregate are equal to at least 5% of the institution’s costs of providing the goods or services. These are four of the six alternatives available for satisfaction of this requirement or criterion.

In addition, the institution must benefit a substantial and indefinite class of persons who are legitimate subjects of charity, relieve the government of some of its burdens, and operate entirely free from private profit motive.

Needless to say, Pennsylvania’s test is sui generis, and other states are likely to have completely different standards and requirements regarding any minimum levels of charity care required for tax-exempt status.

In the case of a tax-exempt hospital system that has operating hospitals in different states, although it may be hoped that a uniform standard eventually will be developed by all or many states, realization of that hope appears unlikely.

Classification of “Charity Care” in Financial Statements

The Auditing and Accounting Guide to Healthcare Organizations of the American Institute of Certified Public Accountants ("AICPA") defines charity care as follows:

Charity care represents healthcare services that are provided but are never expected to result in cash flows. As a result, charity care does not qualify for recognition as receivables or revenue in the financial statements. Distinguishing charity care from bad-debt expenses requires the exercise of judgment. Charity care is provided to a patient with demonstrated inability to pay. Each organization establishes its own criteria for charity care consistent with its mission statement and financial ability. Only the portion of the patient’s account that meets the organization’s charity care criteria is recognized as charity. Although it is not necessary for the entity to make this determination upon admission or registration of an individual, at some point the entity must determine that the individual meets the established criteria for charity care.

The AICPA generally requires nonprofit hospitals to disclose their charity care service policies and the amount of charity care services which they have provided, but the accurate classification and documentation of healthcare services to patients who are unable to pay, as contrasted with patients who may be unwilling to pay, is not always a simple process. An example of some of the problems faced, and the correlation (or lack thereof) of financial accounting standards with legal requirements for tax exemption is illustrated by the opinion of the District Court in the St. David’s case.

In that opinion, the District Court unequivocally concluded that every hospital owned by the St. David’s Health Care System, L.P. provided emergency care without regard to the patient’s ability to pay. In addition, with respect to the government’s arguments that most or all of St. David’s uncompensated care should be classified as bad debt and not as charity care, the Court stated:

“The government attempts to quibble about how St. David’s differentiates between free care that is charity and free care that is bad debt. The Court thinks that is a silly and meaningless distinction for purposes of this case. When all who need emergency care are treated regardless of willingness or ability to pay, the function is charitable regardless of what the accountants discover later. ... [K]nowing that the hospital will not be compensated for much of the care rendered can be sufficient even if it cannot be predetermined which patients can pay and which cannot pay.”

This would seem to constitute an example suggesting that financial accounting standards may not always correlate to applicable legal standards.


Foot NoteGeisinger Health Plan, 985 F.2d 1210 (3d Cir. 1993) (a hospital can satisfy the community benefit standard of Rev. Rul. 69-545, 1969-2 C.B. 117, in a variety of ways, including providing free care to indigents).
Foot NoteEastern Kentucky Welfare Rights Organization v. Simon, 506 F. 2d 1278 (D.C. Cir., 1974), reh’g and banc denied, 506 F.2d 1292 (D.C. Cir., 1974), vac’d on another ground, 426 U.S. 26 (1976).
Foot NoteH.R. 5686, 101 st Cong., 2d Sess. (1990); H.R. 790, 102d Cong., 1 st Sess. (1991); and H.R. 1374 (102d Cong., 1 st Sess. (1991).
Foot NoteNonprofit Hospital (Better Standards Needed for Tax Exemption), GAO/HRD 90-84, GAO Report to the Chairman, Select Committee on Aging, House of Representatives, May 1990).
Foot NoteSt. David’s Health Care System, Inc., 2002-1 U.S.T.C. ¶50,452 (W.D. Tex. 2002), vac’d and remanded, 349 F3d 232 (5 th Cir. 2003).
Foot NoteArticle VIII, section 2(a)(v) of the Pennsylvania Constitution.