IRS toughens its guidelines on tax exemption for HMOs

Healthcare Financial Management, Jan, 1991 by Phillip G. Royalty

IG0058

The Internal Revenue Service (IRS) recently issued long-awaited guidance concerning standards that health maintenance organizations (HMOs) must meet to qualify for exemption from Federal income tax. And as expected, it sets a tough course for HMOs desiring tax-exempt status.

Because the guidance comprises three general counsel memoranda (GCM), it should not necessarily be considered precedent-setting. Nevertheless, it provides valuable insight on how the IRS currently sees the issue. GCMs 39828, 39829, and 39820 primarily address three areas:

  * Exemption standards for HMOs
  under Internal Revenue Code
  (IRC) section 501(c)(3) as charitable
  organizations;
  * Exemption standards for HMOs
  under IRC section 501(c)(4) as social
  welfare organizations; and
  * The effect of IRC section 501(m)
  on the exempt status of HMOs.

Tax-exempt status before section 501(m). Organizations that promote health may qualify as charitable organizations exempt from Federal income tax under IRC section 501(c)(3). One of the requirements of the section states that the organization in question must be organized for community benefit. Any benefit to the private interests of an organization's members must be incidental to serving the community. The IRS initially took the position that HMOs did not qualify for 501(c)(3) status because they primarily provided preferential services to members, as opposed to a community benefit.

In the case Sound Health Association v. Commissioner, however, the tax court upheld the 501(c)(3) status of a staff model HMO (one that provides healthcare services in a central location, with physicians and other professionals working as salaried employees). The HMO in this case provided services to its members on a prepaid basis and to non-members on a fee-for-service basis. The IRS currently follows the Sound Health decision and-before section 501(m) was enacted-had granted 501(c)(3) status to HMOs similar to Sound Health.

HMOs unable to obtain 501(c)(3) status often were recognized by the IRS as exempt under section 501(c)(4) before enactment of section 501(m). Although section 501(c)(4) also contains a community benefit standard, the IRS did not apply the test to HMOs as strictly as the 501(c)(3) standard.

With the addition of section 501(m), an organization is not exempt under either section if a substantial part of its activities consists of providing "commercial type" insurance. If the insurance-like activity is insubstantial, an HMO's exemption is not forfeited. But the activity constitutes an unrelated business or trade that is taxable to the organization under rules relating to insurance companies.

Section 501(m)(3)(B) also states that commercial type insurance does not include incidental health insurance of a kind customarily provided by many HMOs. Section 501(m) became effective for tax years after 1986.

Recent guidance. GCM 39828 listed several key factors that are relevant in determining whether an HMO qualifies for section 501(c)(3) status. The factors basically reflect attributes that existed in the Sound Health case. The IRS made it clear that its list is not all-inclusive and that the absence of any one factor does not necessarily jeopardize an HMO's exempt status. Even so, the test likely will prove difficult for most HMOs:

  * Actually providing healthcare
services and maintaining facilities
and staff;
  * Offering services to non-members
on a fee-for-service basis;
  * Providing care and extending reduced
rates to indigent persons;
OF Caring for persons covered by
Medicare, Medicaid, and similar
programs;
  * Making emergency room facilities
available to the community regardless
of an ability to pay (and
informing the community about
the services);
  * Operating a meaningful subsidized
membership program;
  * Forming a board of directors
broadly representative of the
community;
  * Offering health education programs
open to the community;
he Conducting health research programs;
  * Having healthcare providers who
are paid on a fixed-fee basis; and
  * Using surplus funds to improve
facilities, equipment, patient care,
or any of the programs described
in the list.

Five additional factors are used to determine whether an HMO meets the requirement of section 501(c)(3) that no meaningful restrictions be placed on membership, precluding an HMO from serving the community as a whole:

  * A membership including groups
and individuals, with individuals
composing a substantial portion
of the membership;
  * An overt program to attract individuals
   to become members;
  * A community rating system that
   provides uniform rates for prepaid
   care;
  * Similar rates for individuals and
   groups (with a possible modest
   initiation fee for individuals); and
  * No substantive age or health barriers
   to eligibility for individuals
   or groups.

Determining 501(c)(3) status. Two separate HMOs referred to as Plan A and Plan B, both part of a healthcare system, were the subject of GCM 39828. Both plans entered into contracts for providing healthcare services rather than directly providing care.