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Over the last two decades, there has been a drastic shift in the structure of healthcare institutions. What were once individually owned, community-based hospitals are now large scale, multi-state health systems and corporations. Attempting to analyze these massive healthcare institutions under the same legal framework that was applied when institutions were comprised only of community hospitals is like trying to put a square peg in a round hole. At least, that is the opinion of Chester County Court of Common Pleas Judge Jeffrey R. Sommer, who on October 14, 2021, rejected the tax exemption bid of three LLC hospitals with the sole member of each being Tower Health, in a decision he anticipated—and hoped—would be appealed and lead to a legislative and judicial evaluation of the current framework. Without knowing the outcome of the appeal, which Tower Health executives say is coming, we cannot fully predict the repercussions of this decision. We can, however, note what will be relevant to healthcare networks if the decision is upheld.

Controlling Law

Applying what he called an “ancient framework,” Judge Sommers considered, under a “modern analysis” what might qualify Phoenixville Hospital, Brandywine Hospital and Jennervsille Hospital as tax-exempt charities, using criteria established by the Pennsylvania Constitution, the General County Assessment Law, the Pennsylvania Supreme Court’s test stated in Hospital Utilization Project (HUP) v. Commonwealth (1985), and the Institutions of Purely Public Charity Act, or Act 55, which essentially codifies the HUP test.

The General County Assessment Law (Assessment Law) requires hospitals prove that they are one of purely public charity, are founded by public or private charity and are maintained by public or private charity.

Under the HUP test, to qualify as a purely public charity, five criteria must be met: (1) advance a charitable purpose, (2) donate or render gratuitously a substantial portion of its services, (3) benefit a substantial and indefinite class of persons, (4) relieve the government of some of its burden and (5) operate entirely free from private profit motive. Each criteria must be met, and the court applies a totality of circumstances approach.

Large Executive Bonuses May Strip Health Systems of Non-Profit Tax Exemptions

Each hospital payed three main charges to Tower Health: management fees, central business office fees and interest payment obligation fees. These fees were raised exponentially between 2018 and 2020. For example, the management fee for Phoenixville Hospital increased, in two years, from $3.5 million per year to $21.7 million per year. Tower Health used approximately half of the management fee charged to hospitals to fund executive compensation in fiscal year 2018, with the IRS reporting approximately $6 million in salaries being paid to the administrative team of Tower Health.

Judge Sommer’s decision mainly rested on these excessive management fees and his argument can be summarized as follows. If a health institution acquires hospitals, and charges those hospitals such excessive funds that excise fees are applied against, and to the detriment, of each hospital (not the network itself), the healthcare institution uses those funds to line the pockets of their executives, and then files for bankruptcy, they cannot be said to be charitable in accordance with Pennsylvania law.

It is important to note that health institutions need not be concerned that raising management fees charged to owned hospitals will, alone, render them unable to receive the tax exemption as a result of this decision. However, this case makes clear that the entity raising fees must be able to provide support to those hospitals and the intended charitable beneficiaries (i.e., the patients and residents of their service communities) of their charity, whether through reasoning, studies, or analysis, which might explain the increase in costs, especially when they skyrocket.

Money Loss is Not Synonymous with Charity

Health networks should be on notice that merely presenting themselves as a “money-losing operation” will not equate to being considered charitable under the General County Assessment Law. Judge Sommers, in evaluating the financial exhibits presented by Tower Health, concluded that the management fee demanded by Tower Health was “primarily for the purpose of paying Tower Health executives.” Where a health network requires excessive management fees from acquired hospitals, including interest, and accounting demonstrates that some of those hospitals actually would have made money but for the fees, it cannot be said, under this opinion, to be a money-losing operation. The excessive management fees and executive compensation resonated with Judge Sommer and, based on the facts of the case, seem atypical to most non-profit healthcare compensation structures.

If this decision stands, healthcare networks must scrutinize the income sources that provide substantial revenues income to their hospitals. This court did and this decision clearly questioned the income derived from non-employed physicians, rather than income directly from patient services. This decision also raises concerns regarding the number of physicians employed by independent third party for-profit medical practices. Under this opinion, healthcare systems should structure their hospitals such that they employ individuals who already are part of the system’s staff.  In this case, more than 90% of the physician revenues were from non-employed physicians who only had staff privileges at the hospitals.

The court also pointed out that tax exemption under federal tax law or a business that is not profitable are not synonymous with “charitable” or “charity.”

Defining Uncompensated Costs

The HUP test requires a totality of circumstances approach. Uncompensated Medicare costs and bad debts may be considered, but each case is determined on a fact specific basis. Pennsylvania case law suggests where patient reimbursements from Medicare exceed 45%, it will be determined that those hospitals donate or relate substantial portions of their services.

Uncompensated costs are those costs representing the difference between the actual cost of the services and the reimbursement rate provided by the government programs. Each hospital in this case provided only about .00076% of uncompensated care in their facility. To demonstrate uncompensated costs in accordance with this decision, hospitals should not rely on master sheets stating costs to show lack of compensation. Instead, hospitals must point to agreements with providers that set compensation, and demonstrate how compensation under Medicare and Medicaid programs pay in comparison. Clients also must not write off bad debt as charitable contributions—there is no charitable intention at the time of the provision of services and they do not equal an increase in donated care to those who otherwise could not afford to pay.

Lastly, clients should be aware that, according to this court, compensation plans based on financial productivity are evidence that a hospital does not operate entirely free from private profit motive, as required under HUP. The court notes that a purely public charity must not go beyond self-support, and that Tower Health went “far beyond” it. This is evidenced by incentive compensation plans driven by economic performance – 70% of the hospitals’ plans were driven by economic performance. Health institutions should be certain that their compensation plans do not depend in large part on finances, nor are they designed to “incentivize these employees to drive profits/surpluses.” This is particularly troubling because most, if not all, non-profit hospitals and health systems engage in some level of incentive compensation plans for their executives. So, non-profit healthcare systems must carefully review their compensation plans that emphasize the “bottom line.” Other Pennsylvania courts have similarly held that bonus plans intended to improve business performance, not the hospital’s ability to render charity care, are considered evidence of a profit motive violating the HUP test.

Moving Forward

This case and this issue will not be going away any time soon. There is a trend spreading across the nation where state municipalities, stretched thin for funding from a fixed tax base, are challenging the tax exemption of non-profit hospitals as a way to add additional revenues to help pay for the rising costs of providing necessary services not only to their tax-paying residents, but in most cases, tax-exempt entities such as hospitals and other charities. In the 1990’s, leading to the enactment of Act 55, many municipalities entered into long-term arrangements known as payments in lieu of taxes (PILOTS) and/or services in lieu of taxes (SILOTs) as a means to settle and defuse any potential litigation challenging the tax exemption of Pennsylvania non-profits. It is noteworthy that Judge Sommer in his opinion enthusiastically invites an appeal to this case and others as an opportunity for the appellate courts and the legislatures to review the significant changes that have transformed the delivery of healthcare and to perhaps acknowledge that the existing tests, no matter where found, can no longer be applied to healthcare entities in the U.S. and, in particular, Pennsylvania. And, finally, the facts in this case, as presented, were not all that favorable to the hospitals and were distinguishable from most other non-profit hospitals in Pennsylvania.