Private Inurement Considerations in Recruiting Physicians at
Sec. 501(c)(3) Hospitals

Many hospitals have difficulty recruiting qualified doctors in a variety of specialty areas. In addition, as managed healthcare reaches significant levels within the industry, hospitals and other healthcare organizations frequently must provide recruitment incentives to their networks of primary-care physicians. These recruitment activities have employed a variety of structures and forms, each matched to the needs of the hospital and physicians and to the bargaining power of the parties. However, in structuring physician recruitment packages, tax-exempt healthcare organizations must avoid entering into financial relationships that could result in "private inurement" or impermissible "private benefit."

Definition of "Insiders"

To be exempt from income tax under Sec. 501(c)(3), a nonprofit hospital or other healthcare organization must ensure that no part of its net earnings "inures to the benefit of any private shareholder or individual...." Inurement arises whenever "a financial benefit represents a transfer of the organization's financial resources to an individual solely by virtue of the individual's relationship with the organization and without regard to the accomplishment of exempt purposes" (GCM 38459). Private shareholders or individuals as described in Sec. 501(c)(3) (often referred to as "insiders") are persons with a personal or private interest in the activities of the organization or who are in a position to control or influence the organization.

However, private benefit can exist, regardless of whether the individual receiving the benefit is deemed an insider. Unlike private inurement, in which any amount can jeopardize an organization's tax-exempt status, private benefit may not be inconsistent with exempt status, as long as it is insubstantial when compared to the overall community benefit provided by the organization's exempt activities.

In 1986, the IRS took the position that insiders include a hospital's officers, directors and physicians. Hospitals and physicians have a unique relationship because a hospital relies on its physicians for patient referrals. In GCM 39498, the Service found that, as a result of a hospital's economic dependence on its physicians, the physicians were in a position to control and influence the hospital. Therefore, GCM 39498 advised that all physicians on a hospital's medical staff are insiders subject to the inurement proscription.

For Sec. 4958 intermediate sanction purposes, Congress did not share the IRS's view that all physicians should be considered insiders. In its committee report to the 1996 Taxpayer Bill of Rights, which added that provision, the House Ways and Means Committee stated the following with respect to GCM 39498:

The IRS has issued a general counsel memorandum indicating that all physicians are considered "insiders" for purposes of applying the private inurement proscription. The Committee intends that physicians will be disqualified persons only if they are in a position to exercise substantial influence over the affairs of an organization.

"Disqualified persons" refers to individuals subject to the Sec. 4958 intermediate sanction penalties.

More recently, in Rev. Rul. 97-21, the Service described a set of physicians involved in hypothetical recruiting transactions. In the described situations, the physicians were not deemed to be insiders subject to the inurement prohibition, because they did not have "substantial influence over the affairs of the hospitals...recruiting them." Absent further guidance from the IRS, when a hospital recruits physicians (particularly for managerial roles, such as department heads or administrators), it remains necessary to examine closely the hospital/physician relationship for prohibited private inurement.

Private Inurement

Inurement can occur in any transaction between a Sec. 501(c)(3) organization and its insiders. The Service requires hospitals to demonstrate that the primary purpose of their physician recruitment arrangements is a bona fide community benefit, rather than increased market share or otherwise improved competitive position; see GCM 39862. A hospital that provides recruitment incentives to bring physicians in a needed specialty to a community may be deemed to demonstrate a community benefit that may justify a reasonable recruitment incentive. By contrast, a hospital that provides recruitment incentives to attract physicians previously associated with another hospital in the same community typically will not be deemed to demonstrate the requisite community benefit.

In Rev. Rul. 97-21, the IRS provided five hypothetical examples of hospitals providing recruitment incentives to physicians, some resulting in private inurement. Situation 1 described a hospital located in a remote rural area, with no other hospital within a 100-mile radius. The hospital paid a recruitment incentive, approved by its board of directors, to a specialist to relocate his medical practice to the community. The Service advised that the recruitment incentives paid under these circumstances furthered the hospital's charitable purposes consistent with Sec. 501(c)(3).

Situation 2 of Rev. Rul. 97-21 described a hospital located in an economically depressed inner-city area with a shortfall of pediatricians in its service area. The hospital recruited a pediatrician to work in the community, by providing an incentive package negotiated at arm's length and approved by the board of directors. Similar to the hospital in Situation 1, the hospital had objective evidence demonstrating a need for the pediatrician and had engaged in a recruitment activity that promoted and protected the community's health. Therefore, according to the IRS, the recruitment activity in Situation 2 furthered the hospital's charitable purpose.

Conversely, in Situation 5, a metropolitan hospital had been found guilty of willfully violating the Medicare and Medicaid anti-kickback statute for providing physician recruitment incentives that constituted payments for referrals. These activities were considered substantial in comparison to the hospital's other activities. Therefore, the hospital in Situation 5 did not qualify as a Sec. 501(c)(3) organization.

Excess Benefit Transactions

Prior to Sec. 4958, the Service had three options if it found prohibited private inurement to exist at a tax-exempt hospital: (1) ignore the private inurement, (2) revoke the hospital's exemption or (3) use the prohibited inurement as leverage in negotiating a closing agreement. Sec. 4958 now provides the IRS with the option of imposing penalty excise taxes on a hospital's "disqualified persons" for engaging in "excess benefit transactions" and on any organization managers who "knowingly" participated in such excess transactions. In January 2001, the Service released temporary regulations under Sec. 4958, explaining in greater detail the definition of "excess benefit transactions" and when it can impose intermediate sanction penalties.

Generally, an excess benefit transaction is a transaction in which the value of the economic benefit conferred on a disqualified person exceeds the value of the consideration (including the performance of services) received for providing the benefit (Sec. 4958(c)(1)(A)). The term "disqualified person" includes, for any transaction, "any person who was, at any time during the 5-year period ending on the date of such transaction, in a position to exercise substantial influence over the affairs of the organization."

Notably, the regulations provide an exception that may help Sec. 501(c)(3) healthcare organizations recruit more effectively. Assuming adequate performance by the contracting physician, Sec. 4958 does not apply to any fixed payment made to the physician pursuant to an initial contract, provided the physician was not a disqualified person prior to entering into the contract (Temp. Regs. Sec. 53.4958-4T(a)(3)(i), (iv)). For this purpose, a payment may be considered "fixed" even if it is subject to a fixed formula that incorporates amounts based on future specified events or contingencies, such as revenue streams generated by the tax-exempt organization. Under no circumstances, however, can such an arrangement involve the subsequent exercise of discretion for the amount of payment or reimbursement (Temp. Regs. Sec. 53.4958-4T(a)(3)(ii)). Also, the physician must substantially perform his obligations under the initial contract.

Conclusion

In any recruitment program, it is essential to have documented support for the incentives paid. Such documentation is particularly important should the IRS challenge a hospital to defend the reasonableness of its recruitment incentives, referred to in Sec. 4958 as establishing a rebuttable presumption of reasonableness. Other requirements for establishing a rebuttable presumption include approval by an independent board and reliance on appropriate data. Written documentation of the independent board's decision to pay recruitment incentives or other compensation packages should include justification for paying the incentives that demonstrates benefit to the community, not just to the hospital or physicians. Moreover, hospital recruiters should collect survey data on physicians' earnings and provide it to the board to document that any minimum income guarantee provided as a part of an incentive package would be considered reasonable compensation. Further, recruitment packages should be negotiated at arm's length with physicians. Finally, the hospital's board of directors should approve a recruitment plan to which all recruitment packages must adhere.

From Robert M. Gold, J.D., and Travis L. Patton, Washington, DC