Tax Exempt or Not Tax Exempt? Nonprofit Hospitals and the Exemption Controversy
Tax Exempt or Not Tax Exempt? Nonprofit Hospitals and the Exemption Controversy
Many questions have arisen regarding hospitals’ status as tax-exempt organizations.
Recent court decisions on real estate tax exemptions have caused increasing concern for nonprofit hospitals, which are the target of municipalities that do not think the hospitals are paying their fair share of taxes. The municipalities stand to benefit from increased taxes on nonprofit hospitals, and the nonprofit hospitals stand to lose their tax-exempt status.
This article answers many of the questions that have arisen regarding hospitals’ status as tax-exempt organizations — Why has this issue surfaced? What is the thought process behind revoking hospitals’ tax-exempt status? How can hospitals manage the exemption controversy? What are the tax implications on hospitals if they lose their exempt status? And, more practically, what is the value of a hospital exemption?
Court decisions and legal action
The issue of nonprofit hospitals’ tax-exempt status has surfaced in the wake of the Provena Covenant Medical Center v. Department of Revenue decision in 2010, which determined that Provena was not entitled to a property tax exemption for charitable organizations. The decision in this case was based largely on the argument that Provena did not provide a sufficient amount of charitable care relative to total revenue to qualify as a nonprofit hospital. Relevant facts from the case show that Provena’s charity care, as defined by the state, accounted for less than 1% of the hospital’s revenue. It was the opinion of the court that:
”The burden of establishing entitlement to a tax exemption rests upon the person seeking it. The burden is very heavy. The party claiming an exemption must prove by clear and convincing evidence that the property in question falls within both the constitutional authorization and the terms of the statute under which the exemption is claimed.“
The Provena ruling has touched municipalities and nonprofit hospitals across the country, forcing them to take notice. In May 2016, the Illinois Supreme Court agreed to review a case regarding the constitutionality of tax exemptions. In a similar ruling in 2015, a New Jersey tax court found that Morristown Medical Center should not be exempt from property taxes. As reported, the judge in this case found that the hospital operated similarly to a for-profit business, and stated in the ruling that “for purposes of property tax exemption, modern non-profit hospitals are essentially legal fictions.” Since this ruling, additional similar lawsuits have been filed, and legislative action is in progress to mitigate the legal ramifications. The New Jersey Legislature passed a bill in January 2016 to keep hospital tax exemptions in exchange for fees paid from nonprofit hospitals to municipalities. New Jersey Governor Chris Christie has not yet signed the bill, and additional discussion is ongoing.
Charity care and community benefit
These cases have challenged nonprofit hospitals to manage the resulting controversy. The Provena decision states:
"In explaining what constitutes “charity,” the courts have held that it may be more fully defined as a gift, to be applied consistently with existing laws, to benefit an indefinite number of persons, by bringing their hearts under the influence of education or religion, by relieving their bodies from disease, suffering or constraint, by assisting them to establish themselves for life, or by building or maintaining public buildings or works, or otherwise lessening the burdens of government."
As a result of the Affordable Care Act and expanded Medicaid programs in certain states, nonprofit hospitals’ charity care burden is lessening. Therefore, implementing and improving programs designed to benefit communities are ways to ensure the tax exemption.
An article in Modern Healthcare magazine last year about St. Francis Memorial Hospital in San Francisco corroborates this trend. St. Francis is an example of a nonprofit hospital that has implemented or improved programs designed to benefit its entire community. Through the hospital’s Safe Passage program, volunteers patrol an area of the community affected by drugs and gang violence.
Following in St. Francis’ footsteps, hospitals must adapt to shifting requirements regarding what constitutes a nonprofit entity, especially given the increasing burden of proof to maintain this status.
A valuation advisor can help hospitals structure a proper defense to keep their exempt status or, if they lose their exempt status, determine possible liability. Hospitals that are able to prove that the implied property tax expense (based on the market value of the real estate) is less than the value of the charity benefits provided to the community might be able to use this measuring stick as an argument for keeping their exemption.
An experienced valuation advisor in the healthcare space understands the challenges of appraising hospitals and medical centers and is well versed in property tax issues. For example, an experienced advisor knows that most jurisdictions require the value of the fee simple interest of real property (excluding equipment and intangible assets) in the appropriate valuation of real property for ad valorem taxation. Hospitals and medical centers are special-purpose properties, and operating hospitals typically own assets that are not considered real property. Personal property/medical equipment (e.g., MRIs, CT scanners) and intangible assets (e.g., licenses, certificates of need, assembled workforce, operational expertise, goodwill) are often included in an incorrectly prepared “real” property valuation. Not all valuation assessors have experience valuing these types of properties and accounting for, or isolating, these types of value components.
Oftentimes, local assessing officials apply a sales comparison or income capitalization approach to determine a hospital’s value. Neither of these approaches, however, necessarily values a hospital’s total assets or isolates the real estate value. Looking strictly at “comparable” sales in determining a hospital’s value typically reflects the sale of the hospital’s total assets, not just its real estate. Another consideration in regard to a sales comparison approach is third-party leasing. Hospitals sometimes lease their property to third-party operators, and the lease agreements typically are driven by a ratio of rent to EBITDAR (earnings before interest, taxes, depreciation, amortization and restructuring/rent), which inherently includes business value. An income capitalization approach that focuses on a hospital’s cash flow could be a reasonable basis for valuing the total business, but a hospital typically consists of far more than just its underlying real estate.
In contrast, a cost approach is a suitable way to value hospital real estate for any purpose, including property taxes. The replacement and reproduction costs are determined, appropriate depreciation is applied, and the value of improvements to the physical site (e.g., parking lots, driveways, sidewalks, landscaping) is calculated. The final step is to value the underlying land. By its very nature, a cost approach reflects the value of only the real estate, not any additional components (i.e., personal property/medical equipment and intangibles).
Hospitals that understand the value of their exemption are in a strong position to manage how the exemption controversy affects them.
As the Provena ruling in 2010 and numerous subsequent rulings have shown, taxing authorities and medical facilities alike have reason to be concerned about nonprofit hospitals’ tax-exempt status. In the face of increased scrutiny from taxing bodies, nonprofit hospitals must implement or improve programs in order to increase their charity care and community benefit. An experienced healthcare valuation advisor can help hospitals determine the value of their tax exemption, which is an important step in structuring a proper defense to keep exempt status, and can ensure local assessing officials get the value right if exempt status is lost.