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This Congressional Budget Office (CBO) paper looks at tax exemption for health care institutions--its benefits, costs, history, economic rationale, and status under current law. It points out the issues that recent trends in the medical marketplace and proposals for restructuring raise, and it summarizes some proposed legislative changes. The paper was prepared in response to a request from the House Committee on Ways and Means.

The paper was written by Pearl Richardson of CBO's Tax Analysis Division, under the direction of Rosemary Marcuss and Frank Sammartino. Mark Booth, James L. Blum, Leonard Burman, Gail Del Balzo, Jon Hakken, Harriet Komisar, Alysa McDaniel, and William Randolph provided valuable comments and suggestions. Harriet Komisar and Eric Guille also provided the data for Tables 2 and 3.

Sherwood D. Kohn edited the paper, Chris Spoor provided editorial assistance. Denise Jordan prepared the manuscript for publication. Questions about the analysis may be addressed to Pearl Richardson.
 

Robert D. Reischauer
Director
August 1994
 
 

INTRODUCTION AND SUMMARY

BENEFITS AND COSTS OF THE CURRENT TAX TREATMENT

• Exemption from Federal Income Taxes
• Tax-Deductible Contributions
• Tax-Exempt Financing
• Revenue Losses

HISTORY

ECONOMIC RATIONALE

• The Rationale for a Nonprofit Health Care Sector
• The Rationale for Tax Exemption

REQUIREMENTS FOR TAX EXEMPTION UNDER CURRENT LAW

• The Concept of "Charitable" Activity
• The Criteria for Tax Exemption
• Hospitals
• HMOs
• Commercial Insurers
• Integrated Delivery Systems

PROPOSALS FOR CHANGE

• New Requirements for Tax Exemption
• Intermediate Sanctions
• Health Insurance Purchasing Cooperatives
• Taxable HMOs and Commercial Insurers
• Tax-Exempt Financing

CURRENT TRENDS AND EMERGING ISSUES

• Distinctions Between Taxable and Tax-Exempt Institutions
• Charity Care
• Mergers, Acquisitions, and the Tax-Exempt Sector
• The Growth in Tax-Exempt Financing

INTRODUCTION AND SUMMARY

The tax treatment of health care institutions--particularly hospitals--has been an issue among policymakers, economists, and legal scholars for decades. More recently, the growth of health maintenance organizations (HMOs) and integrated delivery systems (IDSs)--which combine hospital and physician services--the potential expansion of the tax-exempt health care sector, and the prospect of health care restructuring have raised new questions about the basis for exempting health care institutions from taxation.

Some hospitals, HMOs, and IDSs are exempt from the federal income tax; others are fully taxable. Institutions that are exempt from paying federal income taxes usually are also exempt from state and local income, sales, and property taxes. In 1992, nearly 60 percent of all short-term, nonfederal hospitals, accounting for about 70 percent of all hospital beds, were tax-exempt. These include teaching hospitals and academic medical centers, which qualify for tax-exempt status as educational institutions. Approximately 14 percent of all short-term, nonfederal hospitals, representing about 10 percent of beds, were for-profit, investor-owned organizations. The remainder were public.¹ Most HMOs are organized as for-profit operations. Tax-exempt HMOs account for only one-third of the total number of organizations, but represent more than half of all HMO enrollees.²

Tax-exempt institutions fall into two broad classes, depending on whether they are exempt under Section 501(c)(3) or 501(c)(4) of the Internal Revenue Code. Institutions that are tax-exempt under Section 501(c)(3) are eligible for benefits from tax preferences that are not available to other entities. The preferences are access to tax-deductible contributions and relatively unlimited access to tax-exempt financing for capital projects. (Federal law imposes strict limits on the use of tax-exempt financing by other tax-exempt and taxable entities.)

Public policy in this country has long exempted nonprofit health care institutions from income taxes.³ The broad justification for tax exemption is that an institution serves a public purpose. Over the years, new or modified federal programs and growing competitive pressures have brought about changes in the structure and behavior of tax-exempt health care institutions. At the same time, the requirements for tax exemption have changed, primarily through administrative regulation rather than legislative action. Until 1969, health care institutions had to satisfy a requirement to provide charity care in order to qualify for tax-exempt status under Section 501(c)(3); since then, they have had to satisfy a less rigorous requirement to provide a "community benefit." With the possibility of health care restructuring, the standards for assuring that tax exemption serves a public purpose may change again.

The health care bills that the House Committee on Ways and Means and the Senate Committee on Finance have reported out address the issue of public purpose by imposing new requirements for tax exemption on health care institutions and by codifying some of the provisions in existing rulings of the Internal Revenue Service (IRS). The proposals would also strengthen enforcement of the law by leveling new sanctions when an institution fails to comply with the conditions for tax exemption. In addition, the Senate Finance Committee's bill would expand the benefits that are available to Section 501(c)(3) institutions by lifting current limits on their access to tax-exempt financing.

Trends in the medical marketplace and the move toward health care restructuring raise several issues:

• Are the current standards adequate for assuring that health care institutions provide a public benefit in exchange for the benefits they receive from being exempt from federal income taxes? What public purposes are tax-exempt health care providers serving today?
  
  
• What role do the tax benefits associated with tax-exempt status under Section 501(c)(3), particularly the access to tax-exempt financing, play in the delivery of health care and how much do they cost the federal government?
  
  
• With the move toward integration of health care delivery, new forms of organizations are emerging and the variety of institutions under the tax-exempt umbrella is growing. In the future, the public benefit that these new institutions serve and the standards for granting them tax-exempt status may warrant revaluation.

1. American Hospital Association, AHA Hospital Statistics 93/94 (Chicago: American Hospital Association, 1994), p. 7.

2. Group Hospital Association of America, HMO Industry Profile 1993 (Washington, D.C: Group Hospital Association of America, 1993), p. 310.

3. Nonprofit status is a requirement for tax exemption. Thus, all tax-exempt organizations are nonprofit, but not all nonprofit organizations are tax-exempt. Depending on the issue, economists, lawyers, tax specialists, and health care analysts may distinguish between taxable and tax-exempt institutions or between nonprofit and for-profit institutions, For the purposes of this paper, the terms in both cases refer only to private-sector and not to public-sector institutions. Moreover, since virtually all nonprofit hospitals are exempt from taxation, as are most other nonprofit health care institutions, statements and data referring to nonprofit institutions also apply to tax-exempt institutions.

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