The Basics of Establishing and Operating a Charitable Organization—Part 2—Categories of Tax-Exempt Purposes

Section 501(c)(3) sets forth several purposes for which an organization may be organized and operated in order to qualify for tax-exempt status. The following discussion will address some of the more common of these organizations.

Charitable Organizations

The regulations provide for a broad definition of “charity.” The definition includes what might be considered the traditional notion of charity—“relief of the poor and distressed or of the underprivileged.” However, the definition is much more expansive, and includes:

(1) the advancement of religion;

(2) the advancement of education or science;

(3) the erection or maintenance of public buildings, monuments, or works; and

(4) the lessening of the burdens of the government.

It also includes the promotion of social welfare by organizations designed to accomplish any of these foregoing purposes, or to:

(1) lessen neighborhood tensions;

(2) eliminate prejudice or discrimination;

(3) defend human and civil rights secured by law; and

(4) combat community deterioration and juvenile delinquency.

Healthcare Organizations

While the provision of medical and other health-related services is not among the categories of tax-exempt purposes expressly identified in Section 501(c)(3), the provision of healthcare services has long been regarded as falling within the ambit of what is “charitable.” The tax code provides that the following organizations are not considered private foundations and are instead deemed to fall within the ambit of Section 501(c)(3):

(1) hospitals, the principal purpose of which is the provision of medical or hospital care, medical education, or medical research; and

(2) medical research organizations directly engaged in the continuous active conduct of medical research in conjunction with a hospital. At the same time, healthcare is big business. Healthcare organizations operating for profit often provide the same or similar services as those organizations operating on a not-for-profit basis. The healthcare industry, and its methods of delivering services, are fast-evolving. For these reasons, among others, the law regulating the tax-exempt status of healthcare organizations can be less than clear.

Hospitals

In 1956, the IRS issued a revenue ruling, which recognized that “relief of the poor” provided the basis for a hospital’s tax-exempt status, and required hospitals, as a condition for their tax-exempt status, to provide treatment to indigent patients irrespective of whether they could afford to pay for such services. In 1969, the IRS relaxed this requirement and opted for a broader “community benefit” standard by stating in a Rev. Rul. 69-545 as follows:

“The promotion of health, like the relief of poverty and the advancement of education and religion, is one of the purposes in the general law of charity that is deemed beneficial to the community as a whole even though the class of beneficiaries eligible to receive a direct benefit from its activities does not include all members of the community, such as indigent members of the community, provided that the class is not so small that its relief is not of benefit to the community.”

Factors which this revenue ruling found to indicate that a hospital provides a community benefit include:

(1) control of the hospital rests with a board consisting of independent civic leaders;

(2) the hospital maintains an open medical staff granting privileges to all qualified physicians; and

(3) the hospital maintains an emergency room accessible to all irrespective of ability to pay.

Factors which this revenue ruling found to indicate that a hospital instead serves private interests as opposed the community at large include:

(1) control of the hospital rests with persons profiting from the hospital’s operations;

(2) medical staff privileges are restricted to a limited number of physicians; and

(3) the hospital’s emergency room is generally limited to patients of the limited number of physicians who have privileges to practice at the hospital.

In 1992, the IRS published guidelines for determining whether a hospital satisfied the “community benefit” standard articulated in Rev. Rul. 69-545 so as to qualify for tax-exempt status. Factors the IRS takes into account under these guidelines include:

(1) whether the hospital has a governing board composed of “prominent civic leaders” rather than “insiders” such as hospital administrators and physicians;

(2) if the hospital is part of a “multi-entity hospital system,” whether the corporate minutes demonstrate that the hospital is operated as a distinct and separate hospital;

(3) whether admission to the hospital’s medical staff is open to all qualified physicians in the area, consistent with the size and nature of the hospital’s facilities;

(4) whether the hospital operates a “full-time emergency room open to everyone, regardless of their ability to pay;” and

(5) whether the hospital provides non-emergent care “to everyone in the community who is able to pay either privately or through third parties including Medicare and Medicaid.”

A hospital’s failure to maintain an emergency room, either because a state health agency has determined that the hospital’s maintenance of an emergency room would be unnecessarily duplicative of emergency services provided by other area hospitals, or because the hospital offers limited and specialized medical services not involving emergency care, will not necessarily preclude it from obtaining tax-exempt status provided that it meets other requirements indicating that it meets the community benefit standard.

More recently, the Patient Protection and Affordable Care Act of 2010 imposed additional requirements for a hospital to be eligible for tax-exempt status under Section 501(c)(3). First, the hospital must conduct a “community health needs assessment” at least once every three years and adopt an implementation strategy to meet the community health needs identified in the assessment. The assessment must take into account “input from persons who represent the broad interests of the community served by the hospital facility, including those with special knowledge of or expertise in public health” and must be made “widely available to the public.”

Second, the hospital must establish both a written financial assistance policy and a written policy requiring it to provide without discrimination care for emergency medical conditions regardless of an individual’s eligibility under the financial assistance policy. The financial assistance policy must include the following items:

(1) eligibility criteria for financial assistance, and whether such assistance includes free or discounted care;

(2) the basis for calculating amounts charged to patients;

(3) the method for applying financial assistance;

(4) the actions the hospital may take in the event of non-payment; and

(5) measures to widely publicize the policy within the community served by the hospital.

Third, the hospital must limit the amount it charges for emergency and other medically necessary care provided to persons eligible for assistance under its financial assistance policy to not more than the lowest amount the hospital charges persons having insurance for such care. Moreover, the hospital must disallow the use of “gross charges.” Finally, the hospital must not engage in “extraordinary” collection actions before it has made reasonable efforts to determine whether a patient is eligible for assistance under its financial assistance policy. The Treasury Department has issued regulations interpreting these statutory requirements in considerable detail.

Health Maintenance Organizations

In 2003, the U.S. Court of Appeals for the Tenth Circuit addressed the requirements for a health maintenance organization (HMO) to qualify for tax-exempt status as a charitable organization. Observing that the general test for an organization’s tax-exempt status requires that the organization be operated primarily for a “charitable” purpose, and that many for-profit companies provide products and services that promote health, the court found that “[a]lthough providing health-care products or services to all in the community is necessary …, it is insufficient, standing alone, to qualify for tax-exemption under Section 501(c)(3). Rather, the organization must provide some additional ‘plus.’” In describing this “plus,” the court articulated the following test for a healthcare provider to qualify for tax-exempt status:

“[U]nder section 501(c)(3), a health-care provider must make its services available to all in the community plus provide additional community or public benefits. The benefit must either further the function of government-funded institutions or provide a service that would not likely be provided within the community but for the subsidy. Further, the additional public benefit conferred must be sufficient to give rise to a strong inference that the public benefit is the primary purpose for which the organization operates. In conducting this inquiry, we consider the totality of the circumstances.”

In finding that the HMO in question did not qualify for tax-exempt status, the court noted that it did not operate primarily to promote health for the benefit of the community. The court distinguished the HMO from organizations such as hospitals by observing that the HMO did not provide healthcare services directly, but instead provided group insurance allowing participants access to healthcare services in exchange for a fee. The court found that manner in which the HMO established the premiums to be paid for this insurance, which was based upon the risk borne by the HMO, was indicative of a purpose which was primarily commercial as opposed to charitable in nature. Moreover, the court found significant the additional facts in concluding that the HMO was not operated primarily for promoting health for the benefit of the community:

(1) it provided no free or below-cost healthcare services to those unable to afford the premiums;

(2) it conducted no research and offered no educational programs to the public; and

(3) while many were potentially eligible to participate in its group insurance program, eligibility was limited to those who could afford to pay the premiums.

Educational Organizations

Section 501(c)(3) specifically identifies “educational” organizations as qualifying for tax-exempt status. However, not all contributions to organizations which may have an educational mission are necessarily entitled to be taken as a deduction by the donor. In order for a charitable contribution to an educational organization to be deductible, the organization must “normally maintain a regular faculty and curriculum and normally ha[ve] a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.” In other words, the organization must be in the nature of a traditional school in order for charitable contributions to the organization to be deductible.

The regulations define the term “educational” as either relating to (1) the “instruction or training of the individual for the purpose of improving or developing his capabilities,” or (2) the “instruction of the public on subjects useful to the individual and beneficial to the community.”

Regulatory examples of organizations which are deemed educational include:

(1) primary and secondary schools, colleges, and professional and trade schools;

(2) organizations which present public discussion groups, forums, panels, and lectures;

(3) organizations which provide instruction remotely, such as through correspondence, television, or radio; and

(4) museums, zoos, planetariums, symphony orchestras, and similar such organizations.

The “advancement of education” is specifically included within the definition of what is “charitable.” However, educational organizations need not provide free or discounted services in order to meet their “charitable” purpose and qualify for tax-exempt status. As is generally true for all tax-exempt organizations, an educational organization will qualify for tax-exempt status even if it operates a trade or business as a substantial part of its activities provided that “such trade or business is in furtherance of the organization’s exempt purpose or purposes,” and provided that the organization is not organized or operated for the primary purpose of carrying on a trade or business unrelated to its exempt purpose or purposes.

The regulations provide that an organization may be educational even if it “advocates a particular position or viewpoint so long as it presents a sufficiently full and fair exposition of the pertinent facts as to permit an individual or the public to form an independent opinion or conclusion.” The regulations further provide that, on the other hand, an organization will not be considered educational “if its principal function is the mere presentation of unsupported opinion.”

The “full and fair exposition” test was struck down by the U.S. Court of Appeals for the District of Columbia Circuit as violative of First Amendment guarantees of free speech because it was unconstitutionally vague as to: (1) which organizations constitute “advocacy” groups subject to the “full and fair exposition test;” and (2) what requirements such advocacy organizations must meet in order to satisfy the full and fair exposition test.

In response to the ruling, the IRS issued Revenue Procedure 86-43, intended to cure the infirmities found by the D.C. Circuit, and set forth criteria it would use to determine whether advocacy of a particular group may be considered educational. The IRS stated that its focus is not on the substantive content of the organization’s position, but rather the method employed by the organization to develop and present its viewpoints. It went on to state that the method used by the organization will not be deemed educational if it does not provide a factual foundation for the position advocated, or if it does not “provide a development from the relevant facts that would materially aid a listener or reader in a learning process.”

Factors which the IRS stated were indicative that the method used by an organization to advocate a position is not educational include:

(1) the presentation of positions which are unsupported by facts represents a significant portion of an organization’s communications;

(2) the facts which purport to support an organization’s position are “distorted;”

(3) the organization makes substantial use of inflammatory or disparaging terms, and tends to express conclusions on the basis of emotion rather than objective evaluation, in its presentations; and

(4) the organization’s presentations are not aimed at developing the intended audience’s understanding of issues because they do not consider such audience’s background or training in the subject matter of the presentations.

Religious Organizations

Section 501(c)(3) specifically identifies “religious” organizations as qualifying for tax-exempt status, and the regulations specifically identify the “advancement of religion” as falling within the definition of what is “charitable.” However, neither the tax code nor the regulations attempt to define the terms “religion” or “religious.” This restraint is likely due to Establishment and Free Exercise Clauses of the First Amendment, which provide that Congress shall enact no law “respecting an establishment of religion, or prohibiting the free exercise thereof.” While courts have been loathe to inquire into an organization’s doctrines and teachings and make the determination as to whether they constitute a “religion,” courts have found that organizations purporting to be religious nonetheless fail to qualify for tax-exempt status due to other reasons applicable to all tax-exempt organizations, such as violation of the restrictions on private inurement or engaging in excessive lobbying or political campaign activity.

Religious organizations include not only churches and other places of worship, but also include organizations which further religion by engaging in a variety of activities, including the publication of religious publications, the operation of facilities for religious conferences and retreats, and the financing of the construction of church facilities through low interest loans. As is the case for the term “religion”, neither the tax code nor the regulations define the term “church.” Case law has defined a church as “an organization that includes a body of believers who assemble regularly for communal worship.” Moreover, in Revenue Ruling 59-29, the IRS has identified a 14-factor test which it will consider in determining whether an organization bears the badges of a church.

The distinction between a church and other religious organizations is significant. Unlike other religious organizations, churches, their integrated auxiliaries, and conventions or associations of churches are exempt from filing annual information returns with the IRS. This has the practical effect of making it more difficult for the IRS to audit a church, and the IRS may begin such an inquiry only if an “appropriate high-level Treasury official” reasonably believes that the church is not a tax-exempt organization or is engaging in taxable activities. Churches (including conventions and associations of churches) are conclusively presumed to be public charities as opposed to private foundations, whereas other religious organizations are not so presumed. Finally, charitable contributions to churches (including conventions and associations of churches) are entitled to a more favorable deduction than contributions to other religious organizations.

CONCLUSION

Section 501(c)(3) organizations provide those involved in their operation the opportunity to promote a variety of causes that serve the interests of the public at large, as well as more narrowly-tailored interests. However, as should be apparent from the foregoing discussion, it is of critical importance that those involved in their operation be cognizant of the myriad rules governing these organizations’ tax-exempt status. Careful and ongoing planning is therefore critical to ensure that such organizations are able to continue to enjoy their special status and pursue their mission.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Jim Standard is a partner at Taylor, English, Duma LLP in Atlanta. He handles a variety of business transactions, including mergers and acquisitions, stock purchases, asset purchases and other buy-sell transactions.

Copyright © 2020 James Standard