Federal Tax Issues Related to Professional Courtesy and Cafeteria Discounts
by Joy Bode, Mike Watson and J.A. (“Tony”) Patterson, Jr., Fulbright & Jaworski, L.L.P.
Historically, many hospitals have provided discounts on medical services (“professional courtesy discounts”), and cafeteria meals (“cafeteria discounts”) to non-employee physicians on the hospital’s medical staff (“staff physicians”). Some time in the late 1980s and early 1990s, for various reasons, hospitals began discontinuing professional courtesy and cafeteria discounts. One of the driving forces in this change was the enactment of the Stark Law restrictions on physician self-referrals, which affected for-profit and tax-exempt hospitals and hospital systems alike (42 U.S.C. § 1395nn). During the late 1980s and early 1990s, the Internal Revenue Service (“IRS”) also weighed in on the topic of professional courtesy and cafeteria discounts with respect to tax-exempt hospitals and hospital systems. During the course of IRS audits of these exempt organizations ( “EOs”), the IRS often raised concerns about the taxability of discounts provided to physicians and the effect of such discounts on the EO’s tax-exempt status. Many of these EOs were forced as part of their settlements with the IRS to discontinue providing discounts to staff physicians. In addition, the IRS often required the EO to send Forms 1099 to physicians who received discounts during a number of previous years, treating such discounts as income. As a result of these audits, many, if not most, EOs discontinued providing cafeteria and professional courtesy discounts to staff physicians.
The Stark Law regulations issued March 26, 2004, include an exception that allow hospitals to provide professional courtesy discounts to staff physicians under certain circumstances (69 Fed. Reg. 16054 at 16141, 42 CFR § 411.357(s)). As a result, some EOs have begun to offer cafeteria and professional courtesy discounts for staff physicians. However, the provision of professional courtesy discounts in particular, and cafeteria discounts to a lesser extent, raise legal concerns outside the Stark law. For example, professional courtesy discounts raise concerns related to insurance law (including insurance fraud), tortious interference with contracts (for instance, managed care contractual arrangements), fraud and abuse statutes and tax law (as applied to the physician and to the hospital).
It is our experience that there is not a consistent approach taken by EOs in the provision of professional courtesy discounts. Some hospitals routinely provide professional courtesy discounts; other hospitals do not provide them at all; and still other hospitals provide the professional courtesy discounts to a specified maximum dollar amount. Furthermore, some hospitals provide professional discounts only after disclosure is made to the applicable insurance company covering the recipient of the discount benefit, while other hospitals require the written consent of applicable insurance companies to the professional courtesy discount.
There has been less concern, primarily due to the dollar amount involved, with respect to cafeteria discounts; however, there is no consistent approach for those discounts either. Based on the Stark Law regulations, some hospitals are providing meals for free to doctors making rounds at the hospital, while other hospitals provide a discount up to a certain dollar amount per year, some others provide no discount at all. With the re-emergence of these discount programs, it is important to understand the tax issues for EOs as well as the other regulatory constraints.
The principal tax issues can be set out in two questions. First, should the economic benefits provided by an EO to staff physicians in the form of professional courtesy and cafeteria discounts be treated as income to the physicians for federal tax purposes? Second, do the economic benefits provided by an EO to staff physicians in the form of professional courtesy and cafeteria discounts result in private inurement to insiders or excess benefits to disqualified persons?
Section 61 of the Internal Revenue Code (the “Code”) does not adopt a specific definition for the meaning of income. Instead, Section 61 broadly provides that gross income means all income from whatever source derived. Over the years, courts have considered what constitutes income, and while no absolute definition has been adopted, courts have generally concluded that income means the taxpayer has an undeniable accession to wealth which is clearly realized and over which the taxpayer has complete dominion. CIR v. Glenshaw Glass Col, 348 US 426 (1955). Income can be received from many different sources including, for example, found property, the discharge from indebtedness, illegal activities, and fringe benefits. The professional courtesy and cafeteria discounts can be characterized to involve the transfer of something of value from the EO to the physicians for less than fair market value. It is the difference between the fair market value of the goods and services provided – and the price paid for such goods and services by the physicians – that may be characterized as income. However, as broad as the definition of income may be, there are limitations.
When a taxpayer purchases property at arm’s length for less than the property’s worth, the taxpayer is ordinarily not taxed on his shrewd dealings. However, if the bargain aspect of the purchase is not an independent, arm’s length transaction, but reflects other motives of the seller, then the bargain element of the purchase may be taxable to the purchaser. The key issue becomes whether or not the bargain sale is an arm’s length transaction. See IRS Priv. Ltr. Rul. 9814023 (Dec. 23, 1997). On one end of the spectrum, there are transactions, for example, involving a parent corporation and its wholly-owned subsidiary which would not constitute an arm’s length transaction. On the other extreme, there are transactions between sellers and unrelated buyers who walk in off the street and negotiate a bargain sale. See Rev. Rul. 76-96 (Jan. 1976). The latter example would be viewed as being at arm’s length. Unfortunately, the relationship between an EO and its staff physicians is somewhere in the middle.
In Revenue Ruling 76-96, the IRS considered the tax treatment of rebates paid by an automobile manufacturer to certain retail customers. The IRS determined that the negotiations between the dealer and the customer determine the purchase price and that the rebate, as part of the negotiation, represents a reduction in the purchase price of the automobile. Rev. Rul. 76-96. Over the years, Revenue Ruling 76-96 has been the primary source of authority for private letter rulings by the IRS when the IRS determines that a transaction is a bargain sale rather than the receipt of income.
Professional Courtesy Discounts. In 1995, the IRS issued a private letter ruling to a tax-exempt hospital regarding professional courtesy discounts provided to staff physicians, relying on the rationale provided in Revenue Ruling 76-96. Priv. Ltr. Rul. 9525033 (Mar. 22, 1995). The hospital provided a 25 percent discount on inpatient services and a 50 percent discount on outpatient services to staff physicians and their dependents. The IRS considered two countervailing authorities. First, the IRS looked to Section 1.61-21(a) of the Treasury Regulations, which provides that fringe benefits provided in connection with the performance of services are taxable and that the service provider need not be an employee. Treas. Reg. § 1.61-21(a)(3)-(4). Second, the IRS considered Revenue Ruling 76-96 for the proposition that the courtesy discounts represent a reduction in the purchase price of the medical services and are therefore not taxable. The IRS concluded that because the physicians do not provide services to the hospital, the discount is not taxable as a fringe benefit, but is rather treated as a reduction in the purchase price of the medical services because the discount is negotiated at arm’s length.
There are several concerns that make it difficult to rely on Private Letter Ruling 9525033 in the present situation. First, a private letter ruling cannot be relied upon as precedent by other taxpayers. In addition, the ruling is nearly ten years old, and there are no recent rulings that address this specific issue. Finally, the ruling does not appear to fully address the significant factual differences between EOs and physicians on their medical staffs on the one hand, and car manufacturers and retail customers on the other.
Cafeteria Discounts. In a different Private Letter Ruling issued for the same tax-exempt hospital, the IRS considered whether cafeteria discounts provided to senior citizens who purchase a membership card should be treated as taxable income to the senior citizens. Priv. Ltr. Rul. 9506025 (Nov. 8, 1994). The IRS relied on Revenue Ruling 76-96 to determine that the cafeteria discounts represent a reduction in the purchase price. Unfortunately, the facts in many common EO situations materially differ from the facts in this Private Letter Ruling. The senior citizen discount is more similar to the car discounts negotiated between retail customers and the car dealer, because the senior citizens have no existing relationship with the EO other than the agreement related to the discount. Conversely, the staff physicians and the EO do have a preexisting professional relationship, which causes this private letter ruling to be of little value in the present analysis. Additionally, if the cafeteria discount is provided in the form of free meals, it would be hard to argue that the discount equal to the entire value of the meal is a reduction in the purchase price, when there is no actual purchase price paid.
Practical Considerations. Before relying on Revenue Ruling 76-96 or Private Letter Rulings 9525033 or 9506025 for the proposition that the professional courtesy and cafeteria discounts represent a discount in the purchase price rather than taxable income to the recipient, an EO should consider several practical issues. The issue of whether the discounts should be treated as taxable income to the staff physicians may come up in the context of a payroll tax audit. As a result, the IRS payroll tax agent will likely focus on two key issues. First, the payroll agent may turn to the fringe benefit rules under the Code to determine that the discounts are taxable. The agent is likely to focus on the general rule that an economic benefit provided to a person in exchange for services is treated as compensation, unless a specific statutory exception applies. Of course, no specific statutory exception will apply to the professional courtesy and cafeteria discounts for non-employee physicians on the medical staff, so the agent may summarily determine the discounts are taxable without focusing on the proposition that staff physicians do not provide services to the EO. Second, the payroll agent will focus on whether or not the EO sent 1099’s to the staff physicians who received professional courtesy and cafeteria discounts. An EO would be required to report taxable income on Form 1099 for any staff physician that receives more than $600 in taxable income under Code §6041A. (Remember that the Stark Law regulatory exception for non-monetary compensation has a current limit of $300—42 CFR 411.357(k)) It will be a challenge for an EO to put a mechanism in place to track cafeteria discounts given to each physician in each of its cafeterias. Because many EOs will not be able to prove that the total combined discount amount is less than $600, a payroll agent may well assume that a 1099 should have been provided, subjecting the EO to the penalties for failure to file Form 1099.
Whether the Benefits Received Constitute Private Inurement or Excess Benefits. Even if the benefits provided to the staff physicians in the form of professional courtesy or cafeteria discounts do not constitute taxable income, an EO, its representatives and the staff physicians may be in violation of the private inurement or excess benefit rules pertaining to tax-exempt organizations.
Private Inurement. Private inurement exists when any part of the “net earnings” of an organization exempt from tax under Section 501(c)(3) of the Code inures to the benefit of any “private shareholder or individual.” Treas. Reg. § 1.501(c)(3)-1(c)(2). Violation of the private inurement prohibition can result in the loss of the organization’s tax-exempt status. The words “private shareholder or individual” mean persons having a personal and private interest in the activities of the organization. Treas. Reg. § 1.501(a)-1(c). These persons are commonly referred to as “insiders.” Staff physicians are considered insiders for purposes of the private inurement rules. See Announcement 92-83, 1992-22 IRB 59 (setting forth the examination guidelines for tax-exempt hospitals and providing that all physicians are considered insiders and are subject to the private inurement prohibition). The IRS is particularly interested in compensation transactions between hospitals and staff physicians. See Announcement 95-25, 1995-14 IRB 11 (detailing a proposed Revenue Ruling setting forth physician recruitment packages that may be utilized by hospitals to attract non-employee physicians that will not violate the private inurement standard. Each of the permissible recruitment packages involved hospitals with an extraordinary need for qualified physicians and none of the recruitment packages included professional courtesy or cafeteria discounts); Announcement 92-83 1992-22 IRB 59 (providing extensive guidelines for IRS audits of tax-exempt hospitals). As a result of this close scrutiny of hospital and staff physician transactions, any discount provided to staff physicians should be carefully considered.
Although arguments may be advanced under Private Letter Rulings 9525033 and 9506025 that the professional courtesy and cafeteria discounts are not taxable income to the staff physicians, these private letter rulings do not support the proposition that such discounts do not constitute private inurement. The private letter rulings specifically provide that no ruling is being made under any provision of the Code other than Section 61. See PLR 9506025 (providing that the issue of whether the discounts offered are consistent with the tax-exempt status of the hospital is an issue within the jurisdiction of the Exempt Organizations Technical Division and that no opinion is expressed concerning the treatment of the discounts under any other provision of the Code); PLR 9525033 (providing that no opinion is expressed as to the federal tax consequences of the discounts under any other provision of the Code).
In addition, in an older General Counsel Memorandum addressing the issue of whether professional courtesy discounts constitute private inurement, the Acting Chief Counsel stated that professional courtesy discounts provided to staff physicians may constitute inurement to private individuals even though tax-exempt hospitals have traditionally provided such discounts. See Gen. Couns. Mem. 34135 (June 2, 1969). The Acting Chief Counsel also stated that it would “not be appropriate” to revoke the determination letter on the grounds that the hospital has been providing professional courtesy discounts to staff physicians, because such discounts are traditionally provided by similar hospitals with the knowledge of the IRS. Based on the previous inaction of the IRS, it made sense that the IRS, in the 1980’s and 1990’s, simply required hospitals to stop providing professional courtesy discounts to staff physicians. Now that the IRS has established its position against such activity, the IRS may be less lenient in future audits dealing with professional courtesy discounts.
Excess Benefit Transactions. In 1996, Congress passed legislation establishing an excise tax on excess benefit transactions. This excise tax is commonly referred to as “intermediate sanctions” because it is an alternative to the revocation of the entity’s tax-exempt status. In many cases prior to the enactment of the intermediate sanctions legislation, the punishment (revocation of the tax-exempt status) would not fit the crime (minor violations of the private inurement prohibition); therefore, the IRS took no action other than to request that certain transactions be stopped. Under the Code provisions and the subsequently adopted Treasury Regulations, the excise tax applies if a “disqualified person” of a tax-exempt organization engages in an “excess benefit transaction” with the organization. Code § 4958. The term “disqualified person” includes, among other categories not relevant to the present situation, persons with substantial influence over the affairs of the organization and family members of a disqualified person. Id. Under this definition, a physician who is a department head or works in another administrative capacity for the hospital may be a disqualified person, and as a result, such physician’s dependents would also be considered as disqualified persons. In addition, other staff physicians may be disqualified persons, depending on the circumstances. The Code provisions and the Treasury Regulations require a case-by-case analysis of each transaction to determine if the excise tax applies. The term “excess benefit transaction” means a transaction in which a tax-exempt organization provides an economic benefit to or for the use of a disqualified person, directly or indirectly, the value of which exceeds the value of the consideration received in exchange. Id. Under this definition, professional courtesy and cafeteria discounts could be treated as excess benefit transactions.
The excise tax is assessed against the disqualified person and possibly organizational managers who participated in the transaction. Id. An organizational manager would include officers (including persons who are not designated as such but have the powers to make administrative and policy decisions on behalf of the entity), directors, trustees or persons having powers or responsibilities similar to those of officers, directors or trustees. The excise tax for disqualified persons is initially 25 percent of the excess benefit but can be increased to an additional 200 percent of the excess benefit if not corrected. Id. The excise tax for organizational managers, if applicable, is 10 percent of the excess benefit. Id.
Because the IRS has previously stated its concern generally with professional courtesy discounts, it is possible that a subsequent audit by the IRS could result in the imposition of excise taxes for at least some of the staff physicians and possibly EO employees who participated in the transaction.
Conclusion. Professional courtesy and cafeteria discounts, depending on the circumstances, may be treated by the IRS as taxable income to the staff physicians. Even if an EO is comfortable with characterizing the professional courtesy and cafeteria discounts as bargain sales and not as taxable income to the staff physicians, there remain private inurement and intermediate sanctions concerns. As discussed above, private inurement exists when the net earnings of a tax-exempt organization inure to the benefit of an insider, which includes staff physicians. Given the drastic nature of the penalty for violating the prohibition on private inurement, the IRS may hesitate to penalize small violations occurring from the cafeteria discounts. However, it may not be worth the risk to assume the amounts are immaterial.
EOs are well advised to consider carefully the tax aspects of medical staff discount programs in addition to the health law regulatory issues that seem to dominate the discussion. Until more formal guidance comes from the IRS, taking into account the potential penalties involved, careful consideration of the taxability of the discounts and proper reporting of the discounts is essential. Thought should be given as well to obtaining a formal private letter ruling from the IRS.