IRS rule could mean fines for expensive physicians

Doctors, not hospitals, could be fined thousands

Hospitals that purchase physician groups at high premiums could find themselves in serious trouble with the Internal Revenue Service (IRS) if they are not careful with their financial negotiations. That’s the gist of proposed regulations published in the Federal Register for a public comment period before enactment.

The IRS wrote these regulations to describe how it plans to implement penalties of legislation passed two years ago. The legislation empowered the IRS to levy fines against physicians and others who engage in improper transactions with charitable organizations. The law is of concern to physicians who do business with tax-exempt hospitals.

"For as long as we’ve had tax-exempt hospitals, for decades and decades, there has been a prohibition against paying too much to insiders of a hospital or any charitable organization," says LaVerne Woods, JD, a tax and health law attorney and a partner with Davis Wright Tremaine in Seattle.

"The problem has been that if the IRS came in and said You’ve paid too much for these organizations,’ the only thing they could do is revoke the hospital’s tax exemption," Woods adds.

However, the IRS was reluctant to take such a drastic action because it might punish an entire community that rely on the hospital, says Rick Ellingsen, a partner with Davis Wright Tremaine in Los Angeles.

The law gives the IRS another option. Currently, hospitals are allowed to keep their tax-exempt status, and fines are levied on physicians or others instead, Ellingsen says.

These rules could place physicians in a disadvantaged position during negotiations with hospitals.

"Right now, we don’t have [any] hard cases. We don’t know what the IRS will do in terms of enforcement." But Ellingsen says it’s likely that hospitals will second-guess some of their existing contracts with physician groups and make significant changes during renegotiation.

The regulations would penalize "disqualified persons" who engage in financial negotiations with tax-exempt organizations. The sanctions will apply when two things happen, Woods explains. First, an individual has to be determined a disqualified person. Second, the disqualified person has to be receiving too good of a deal.

"If you have a doctor who is paid above the fair market value but is not disqualified, then you don’t have a penalty," Woods says.

Here’s an example of how the proposed regulations would work: Suppose a tax-exempt hospital wants to purchase a local obstetrics/gynecological group. The group’s physicians negotiate a very sweet deal, and end up earning a higher salary than before.

Did the hospital pay too much?

The trouble is when the hospital begins to lose money on the physician group (which is not uncommon for hospitals that purchase physician practices). Maybe the group is not making as much money as the hospital expects. The IRS checks out the situation and determines that the hospital paid too much for the physician group and is paying the physicians higher-than-usual salaries.

This is where the trouble starts: Suppose one of the group’s physicians has a financial stake in a provider-sponsored organization (PSO) that is partially owned by the nonprofit hospital or the the director of the hospital’s women’s center, and the IRS determines that the hospital has paid the physician $50,000 too much per year?

That would make the physician a disqualified person, and the IRS requires the physician to repay the excess income and benefits he or she received from the hospital. Additionally, the IRS would fine the physician 25% of the excess benefit, which would be $12,500 in this case.

Consequently, if the hospital and physician group fail to correct these errors, the IRS could fine the physician an additional 200% of the excess benefit, which would amount to $100,000 in this example.

The proposed regulations have many more implications. Physician Relations Update asked Woods and Ellingsen to explain how these proposed regulations would affect physicians. Here are their answers to our questions:

1. Who are the disqualified persons?

Before the proposed regulations were released, the health care law community worried that the IRS would make all physicians "disqualified persons," Woods says.

However, this is not the case. The ordinary staff physician is not a disqualified person. Each case will be judged separately. "You have to look at the facts and circumstances to see how much influence they have over a department and how much budgetary authority they have," Woods says.

An example of disqualified person might include the head of a cardiology department, or a physician who has some budgetary control in the hospital, Ellingsen says.

"Anyone who is a board member of the hospital automatically is a disqualified person," Woods says. "Anyone who is a chief executive officer or a chief financial officer is a disqualified person."

The proposed regulations require that you must look at all facts and circumstances to determine who in fact is a disqualified person. The regulations list the following facts and circumstances as red flags that would cause IRS investigators to investigate a possible instance of a disqualified person:

— a tax-exempt organization’s founder;

— a substantial contributor;

— someone whose compensation is based on revenues from a tax-exempt organization’s activities that the person controls;

— someone who has control over a significant portion of an organization’s capital expenditures, operating budget, or employee compensation;

— someone who is a manager or serves as a key advisor to a manager;

— someone who owns a controlling interest in a corporation, partnership, or trust that is a disqualified person;

— any person who has a material financial interest in a PSO.

2. What are the penalties?

Disqualified persons may be fined 25% of the excess compensation they received from the tax-exempt organization, Woods says. They also have to return all the excess money and essentially "undo" the situation that caused the tax-exempt organization not to make as much money as it should have.

"It has to be corrected, and you have to put the hospital back in a position no worse than it would have been if they started out at arm’s length," Woods explains. "It’s unclear whether you have to pay back the full amount, or what’s reasonably possible under the circumstances," Woods adds. "But if you haven’t done what the IRS believes is sufficient to correct the deal, then this person has a 200% tax on excess, on top of the 25% penalty."

The proposed regulations also impose a penalty on the tax-exempt organization’s officers and directors who approve the transaction that creates the excess benefit. Also, any board members or a chief executive officer who approve the purchase of a physician practice also could be subject to a penalty, Woods says. However, this is only if they knew beforehand the transaction would result in an excess benefit. The fine in this case would be 10% of the excess amount, with a $10,000 cap, Woods adds.

3. Who is exempt from being named a "disqualified person"?

The regulations state any employee who receives a salary and benefits less than $80,000 is not disqualified, as long as the person is not on the list of disqualified people based on the criteria discussed in point No. 1. This dollar amount can change.

Although there are no hard-and-fast rules that eliminate someone from being a disqualified person, there are three situations that support this classification in most cases:

— any person who has taken a vow of poverty as an employee or on behalf of a religious organization;

— anyone who is an independent contractor, including attorneys, accountants, investment managers, and advisors;

— anyone who receives preferential treatment based on the size of his or her donation, as long as it is part of a solicitation intended to attract donors. This treatment is also offered to other donors making comparable contributions.

4. How is an "excess benefit" defined?

If the hospital provides compensation, services, or other benefits that are greater than the true market value to a disqualified person, then that is an excess benefit, Woods says.

"Where a hospital has acquired a medical practice, issues that tend to come up are the purchase price the hospital paid for the practice, and whether they paid too much for it," she explains.

The IRS will likely scrutinize situations where tax-exempt hospitals manage medical practices, Ellingsen says.

"This could force a disruptive renegotiation of contracts," Ellingsen says. "I think hospitals went into these management relationships in good faith; but probably, they weren’t as knowledgeable in negotiating a deal, or they didn’t know the business — and as a result, the hospital has been hit with huge losses." If this is the situation, it will send up red flags for the IRS.

5. When would transactions be subject to new regulations?

These regulations do not apply to any transaction under a contract signed prior to Sept. 13, 1995, when the law became effective.

(The proposed IRS intermediate sanctions regulations appear in the Aug. 4, 1998, edition of the Federal Register. Written comments may be submitted to the IRS through Nov. 2, 1998.)