Sunday, September 23, 2018

Musings on the Meaning of “Primary”

The recent Illinois Supreme Court decision in Oswald v. Hamer, which I discuss here, got me thinking about the meaning of an all-important word in charitable tax exemption.  That word is “primary.”  Almost all law dealing with charitable tax exemption includes a requirement that charitable activities be “primary” to the organization (or in case of property, the use of the property).  The “primary” test usually is derived from the word “exclusively”: Section 501(c)(3) tells us that an organization is charitable if it is organized and operated “exclusively” for charitable purposes, but the IRS and courts have held that “exclusively” really means “primarily” – some non-charitable use is permissible.  Similarly, the Illinois Supreme Court and virtually all other state supreme courts who have grappled with the issue have held that “exclusive charitable use” really means “primarily charitable use.”  So the key word in establishing a right to charitable tax exemption, whether for federal income tax or state property (or other) tax is “primary.”

So how do we know when charitable activity is “primary”?  Often, this is easy.  Many charities literally do nothing but pursue their charitable purpose.  The Salvation Army or Goodwill Industries may operate thrift stores, but that operation is solely to fund their charitable mission of helping the homeless, poor and disadvantaged.   The Lincoln Center in New York City is all about advancing the performing arts.  And so on.

But for some organizations, like nonprofit hospitals, “primary” is not so clear.  If we believe that simply operating a hospital that provides health services to paying patients is a charitable purpose, then of course “primary” isn’t a problem.  But although the IRS seemed to say exactly this in Rev. Rul. 69-545, we all know now that this isn’t true; the IRS has said many times since then that merely providing health services to paying patients isn’t enough.  Similarly, if we believe that operating a community hospital “open to all without regard to ability to pay” is sufficient, then we don’t have to much worry about “primary” – all nonprofit hospitals claim this is true; if the claim and “official policy” is enough, the issue is decided.

But let us suppose that we want nonprofit hospitals to actually engage in some sort of specific activities that are observable and quantifiable.  In that case, the first part of defining “primary” would be defining the activities one thinks are charitable.  Unfortunately, there is little consensus on what those activities should be.  Should charitable activities in the context of health care be limited to free or discounted care for the uninsured?   Should it be expanded to a broad array of so-called “community benefits” which may include things like “health fairs,” community wellness seminars, and so forth?  Should it be (as I once opined) things that expand access to health care for underserved populations or providing services that for-profit providers do not provide?

For purposes of this thought experiment, let’s assume that we define charitable activities for nonprofit hospitals as expanding access to underserved populations.  Free care for uninsured poor obviously would count here, as would the costs of care below reimbursement for programs such as Medicaid that are aimed at poor populations.  I might throw in educational seminars for at-risk populations and a few other things as well, but the specifics at this stage are unimportant.  Let’s just focus for now on “expanding access” as the charitable goal, whatever the exact contours of that might be.

Fine, now we can move on to the even harder question.  How do we assess whether a nonprofit hospital is “primarily” about such a charitable mission?  Does this test require us to find that more than 50% of the hospital’s services go towards the expanding access goal?  More than 50% of its revenues?  What evidence would tell us that a hospital’s work is “primarily” charitable?

To think about this more, let’s abstract the problem – that is, take it out of the hospital context and think about a more familiar, but no less complex, context.  Many of us (me included) would say that our families occupy a “primary” position in our lives.  What does that mean?  How does a human being illustrate that is true?  Note that it probably does not mean that we spend more than 50% of our waking hours with our families.  Many of us are at work more hours during the week, month or year than we spend interacting with our families yet our families really are “primary.”  So a quantitative “51% of the time” test won’t work.  But we might observe that the work is done so that we can support our families economically; our profit from work goes to making our families’ lives (as opposed to just our own) better.  We might try to be as efficient as possible at work so that we can spend more time (maybe not that magic 51%) with our families.  We might re-arrange our work schedules to attend important family events.  If there is a family crisis, we might even leave in the middle of something very important work-wise to attend to that.  So I would say that while “primary” in this abstracted context cannot be precisely defined quantitatively, it CAN be defined through a combination of quantitative (how much time/money to do you spend on your family) and qualitative (do you take actions that indicate that “family comes first”) factors.

Now let’s go back to the hospital context.  If a hospital must engage “primarily” in charitable activities, and for this thought experiment, we define charitable activities as “expanding access,” then how would a hospital demonstrate that charity is “primary”?  Certainly, the amount of money and time spent on expanding access would be important, but just like a person might spend more time at work than with family and still rightly claim family to be “primary,” we should not simply impose a “51%” test on hospitals.  Time and money spent, nevertheless, are important, and we should demand that substantial time and money be spent.  That in turn leads to a question of what would be “substantial.”  Less that 50%, I should think, but enough that one could see importance to the endeavor.  I’ve previously used 1/3 as a benchmark, but perhaps this is too much.  The IRS has defined substantial as 10% in other contexts, and churches often frame tithing around a “10% of income to charity” obligation.  We can argue about the number, and how to precisely define it, but if a hospital cannot show that at least 10% of its financial wealth and time are spent on charitable activities, then I have a hard time classifying such activities as “primary” no matter what else it does (and perhaps I'm being too generous with a 10% test).

But a quantitative 10% number should not be enough.  Instead, we should also look for qualitative factors of “primary-ness.”  These qualitative factors, I think, should revolve around a demonstration by management that charitable activities are of first importance.  Do meetings of management focus on ways to expand access or are those meetings invariably about the profit margin?  If the hospital has a “good year” financially, does management discuss how to devote more resources to the charitable mission, or are the discussions about raising salaries and salting away the money for a new building or new equipment that may or may not be necessary?  Does management ask for reports from all of the hospital service departments on how they are working to expand access?  Or are the reports about departmental margins and financial efficiency?  Does the hospital “sell itself” to poor or at-risk patients, or does it try to hide that aspect of its operations as much as possible consistent with state law (e.g., does it go “above and beyond” legal requirements or do "the bare minimum")?

There was a time in our history (in the late 1800’s and early 1900’s) when hospitals clearly met both my quantitative and qualitative musings on “primary.”  They were run primarily to serve the poor; if you were financially well-off, you had a personal physician who would treat you (and one hoped not kill you).  If you were poor, you went to a hospital to be cared for by what were nearly always volunteers.  But this is not the way hospitals operate today, and I suspect if we are serious about the word “primary” as a test of charitable exemption, most private nonprofit hospitals would fail that test.  So be it.


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Interesting! I see similarities to the debates about defining "social welfare" activity of 501(c)(4) groups. You touch on one factor that figures prominently in these social welfare discussions - the factor of time. Must a test be applied annually, since 990s and state filings are done annually? Can it be assessed cyclically or periodically, as some advocate that 501(c)(4) activities be reviewed for each election cycle (usually two years).

The "good year" vs. "bad year" problem is especially timely for nonprofit hospitals since revenue and operating margins (profit) for many hospitals and systems are extremely volatile at present.

Posted by: Michael L. Wyland | Sep 24, 2018 7:33:43 AM

A second comment: I remember there being significant health system litigation in Pennsylvania over this topic, as their statute is rather emphatic about "exclusive" charitable activities and some healthcare entities (UPMC comes to mind) are large enough and diverse enough in their activities to invite scrutiny over strict adherence to the intent of state statute.

Posted by: Michael L. Wyland | Sep 24, 2018 8:36:35 AM

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