The four-part HC Topics Series: Healthcare Valuation examined the various aspects of valuation related to the healthcare industry, and is excerpted from the book authored by HCC CEO, Bob Cimasi, entitled, “Healthcare Valuation: The Financial Appraisal of Enterprises, Assets, and Services,” to be published by John Wiley & Sons later this year. The first installment discussed the application of the Fair Market Value and commercial reasonableness standards utilized by various regulatory bodies in valuing healthcare enterprises, assets, and services.  Part II addressed the valuation of intangible assets, and Part III addressed the valuation of physician services.  The fourth and final installment of the series examines the regulatory issues present during the valuation of a tax exempt organization.

Market Activity

The increasing government scrutiny of the business activities of healthcare providers over the past several decades has led to tightened restrictions and increased regulatory enforcement of tax exempt organizations.  Many types of business arrangements, which would be regarded as typical motivations inherent in commercial relationships between parties in other industries, are perceived as exhibiting the potential for a significant risk of fraud in the U.S. healthcare industry. With continued consolidation, integration, and affiliations among various healthcare providers and enterprises, those transactions that involve tax exempt organizations are likely to continue to receive regulatory scrutiny in the coming years. Accordingly, parties to these transactions need to ensure that they are in compliance with IRS standards regarding excess benefit and inurement of benefit, as well as applicable fraud and abuse regulatory requirements related to establishing Fair Market Value and commercial reasonableness. See part one of the HC Topics Valuation Series: A Look at Fair Market Value and Commercial Reasonableness.

The current healthcare industry is focused on the coordination of care and integration among various providers. As healthcare expenditures continue to outpace the general rise in price of most other goods in the U.S. economy, and in light of the fact that the U.S. government is the largest payor of healthcare services, there is a reasonable likelihood of continued consolidation in the healthcare delivery system in an effort to achieve some semblance of scale economies. 

Consolidation among providers (either through physician employment, mergers, or joint ventures between healthcare enterprises) has already begun to impact the competitive nature of the U.S. healthcare environment. Hospital mergers are one illustration of this consolidation; in 2012, there were 89 transactions among hospitals, as compared to 72 in 2000, and 49 in 2005.¹ Likewise, the number of physicians employed by hospitals has grown by 32 percent since 2002, to 212,000 physicians in 2012, accounting for 20 percent of all practicing physicians.² Many of these transactions involved tax exempt organizations.

Legal Issues

Corresponding with the continuing trend of hospital employment of physicians, there has been an increase in regulatory scrutiny related to the legal permissibility of these arrangements under federal and state fraud and abuse laws, i.e., Stark, Anti-kickback, and False Claims Act, as well as IRS regulations regarding transactions involving tax exempt organizations. While some IRS regulation of tax exempt organizations mirror the language found in the fraud and abuse prohibitions listed above, one of the main issues for tax exempt entities is the IRS prohibitions against excess benefit or inurement of private benefit.

A tax exempt organization, such as a non-profit hospital, is generally permitted to sell one or more of its assets to another tax exempt organization or a for-profit entity, so long as fair market value consideration is received for the sale.³ In those circumstances in which the purchaser of the tax exempt organization’s assets is an organization created by individuals related to the exempt organization, e.g., physicians practicing at the non-profit hospital or members of the non-profit hospital’s board of directors, these individuals will be treated as insiders by the IRS and the transaction will receive strict scrutiny by the IRS to ensure that there are no excess benefit(s) or inurement of private benefit(s) between the tax exempt organizations and disqualified persons. ⁴ 

An excess benefit transaction can be characterized as a transaction in which, “…the value of the economic benefit provided exceeds the value of the consideration received for providing the benefit”⁵  Additionally, the IRS defines inurement of private benefit as when an exempt organization is “…organized or operated for the benefit of private interests…” and has explicitly stated that, “[n]o part of the net earnings of a section 501(c)(3) organization may inure to the benefit of any private shareholder or individual[, whereby] a private shareholder or individual is a person having a personal and private interest in the activities of the organization.”⁶ However, prohibitions related to excess benefits and inurement of private benefit do not unilaterally prevent tax exempt organizations from paying financial incentives (e.g., shared savings related to quality improvements or other incentive compensation arrangements) to physicians as part of the compensation package.

In General Counsel Memorandum (GCM) 35638, published on January 28, 1974, the IRS noted that even compensation arrangements that involved shared savings related to quality improvements could be acceptable if they were at arm’s length and were “…a means of providing reasonable compensation to employees without any potential for reducing the charitable services or benefits otherwise provided…” [emphasis added].⁷

In the past, excess benefit transactions were considered together with other private benefit inurement’s, and violations were subject to total revocation of the organizations tax exempt status as the sole remedy.⁸  In 1996, the Taxpayer Bill of Rights 2 authorized the IRS to impose intermediate excise taxes (a penalty short of exempt status revocation) against the disqualified person who received the excess benefit and on the organizational manager who knowingly participated in the transaction.⁹ 

In the final regulations published on March 28, 2008, the IRS identified five factors to be considered when determining whether the organization should be subject to an intermediate excise tax or whether the organization’s exempt status should be revoked in the event that an exempt organization is found to have participated in an excess benefit transaction: (1) the size and scope of the organization’s ongoing activities; (2) the size and scope of the excess benefit transaction in relation to regular activities; (3) whether excess benefit transactions happened in the past; (4) whether the organization has implemented safeguards against this type of transaction; and, (5) whether the excess benefit transaction has been corrected, or there has been a good faith effort to do so.¹⁰ These last two factors are given a greater weight when considering whether to allow an exempt organization to maintain its tax-exempt status in those cases in which the exempt organization has taken steps to remedy the situation.¹¹ 

Series Conclusion

Valuation analysts whose healthcare engagements have been focused on appraising historically “traditional” provider organizations, e.g., physicians in solo and small group practices, are seeing a decline in their client base as the healthcare industry consolidates, and greater numbers of providers form new and larger emerging healthcare organizations (EHOs). These EHOs are driven by the need to develop new affiliations, capital structures, and governance configurations, in order to align the interests of various healthcare industry subsectors, e.g., inpatient and outpatient providers, suppliers and vendors, payors, and consumers, in such a manner as to address the rise of Accountable Care Organizations and other value-based reimbursement initiatives. As the U.S. healthcare delivery system continues to navigate the tumultuous transactional landscape, it will be central for healthcare enterprise and providers to obtain a certified opinion of value as to whether the proposed transaction is both at Fair Market Value and commercially reasonable in order to ensure that the proposed arrangement is in compliance with applicable regulatory requirements.

Healthcare Valuation Series Part III: The Valuation of Physician Services

Healthcare Valuation Series Part II: The Valuation of Intangible Assets

Healthcare Valuation Series Part I: A Look at Fair Market Value and Commercial Reasonableness