Report 2007-107 Summary - December 2007
Inconsistent Data Obscure the Economic Value of Their Benefit to Communities, and the Franchise Tax Board Could More Closely Monitor Their Tax-Exempt Status
Our review of tax-exempt hospitals revealed the following:
- About 223 of California's 344 hospitals are eligible for income and property tax exemptions because they are organized and operated for nonprofit purposes.
- Comparing financial data reported by nonprofit and for-profit hospitals indicated the uncompensated care provided by the two types of hospitals was not significantly different.
- Benefits provided to the community, which only nonprofit hospitals are required to report, differentiate nonprofit hospitals from for-profit hospitals, but the categories of services and the associated economic value are not consistently reported among nonprofit hospitals.
- The values of tax-exempt buildings and contents owned by nonprofit hospitals are frequently misreported by county assessors.
- Lacking more reliable data, we used the reported economic values of community benefits and tax-exempt property to estimate that reported community benefits of $656 million for 2005 were roughly 2.7 times the estimated $242 million in state corporation income taxes and property taxes not collected from nonprofit hospitals.
- The Franchise Tax Board, which administers state income tax exemptions, could better use available tools, such as annual filings and audits, to monitor the continuing eligibility of nonprofit hospitals for their tax exemption.
RESULTS IN BRIEF
State law permits certain organizations, including hospitals, to obtain exemptions from paying state corporation income taxes (income taxes) and local property taxes if they are organized and operated for nonprofit purposes. California has roughly 344 private hospitals in operation, of which about 223 are eligible for income and property tax exemptions because of their nonprofit status. State law gives the Franchise Tax Board (tax board) the responsibility of determining whether an organization, such as a nonprofit hospital, qualifies for an exemption from paying income taxes, and the State Board of Equalization (Equalization) and county tax assessors (county assessors) are responsible for determining whether nonprofit hospitals qualify for an exemption from paying local property taxes.
State law also requires the Office of Statewide Health Planning and Development (Health Planning) to annually collect financial information from hospitals and other health facilities. Hospitals are required to follow Health Planning's accounting and reporting manual when reporting their financial information. Included in the financial information are amounts that Health Planning uses to estimate the value of care that nonprofit and for-profit hospitals provide without receiving compensation (uncompensated-care costs). However, because the term uncompensated-care cost can include many different categories of care, Health Planning has provided three methods of estimating those costs using combinations of three accounts reported by the hospitals: charity care, bad debt, and the contractual adjustment for the county indigent program (CIP). The charity care account includes the unpaid charges for services provided to a patient whom a hospital determined cannot pay in part or in full. Bad debt is the uncollectible payment that a hospital expected a patient to pay but did not receive. The CIP is a program unique to California that is available to certain individuals the State has identified as indigent. The CIP contractual adjustment account is charged with the difference between the amount the hospital received under the CIP and the amount it would have charged a patient who could pay.
According to Health Planning, it chose the three components of its estimates of uncompensated-care costs to be similar to national standards and still take into account the unique reporting requirements of the CIP. Although Health Planning limits its estimate to three components, we expanded the estimate to include a fourth component—the unreimbursed costs of providing services to those eligible for Medi-Cal. We included Medi-Cal costs because (1) the guidance provided to hospitals by the American Hospital Association identifies those costs as a component of uncompensated-care costs and (2) Medi-Cal costs are significant to both nonprofit and for-profit hospitals.
Using the total financial data for charity care, bad debt, and the CIP contractual adjustment obtained from Health Planning, we compared the uncompensated-care costs of the nonprofit hospitals with those of for-profit hospitals for the five-year period from 2001 to 2005, both including and excluding Medi-Cal costs. When taken as a percentage of net patient revenues—the actual amounts a hospital receives from patients and third-party payers, such as health coverage programs—the uncompensated-care costs of the two types of hospitals were not significantly different, both including and excluding Medi-Cal costs. However, the various community benefits that nonprofit hospitals provide differentiate them from for profit hospitals.
State law also requires that most tax-exempt hospitals annually submit a community benefit plan (plan) to Health Planning. However, the law clearly states that a plan cannot be used to justify the tax-exempt status of a nonprofit hospital. A plan must describe the activities the hospital has undertaken to address community needs and must assign and report the economic values of the community benefits the hospital provides. In addition, it must list services that would be provided to the community by both nonprofit and for-profit hospitals, as well as services that only tax-exempt hospitals are required to report, such as community oriented wellness and promotion, medical research, and other outreach activities.
Although state law requires that tax-exempt hospitals submit plans to Health Planning, it does not require Health Planning to review the plans to ensure that hospitals report the same types of data consistently, nor does Health Planning do so. Our review of the plans submitted by a sample of eight tax-exempt hospitals and our discussions with hospital staff revealed differences in the categories included in the plans and the methods used to calculate the economic values of community benefits. For example, some plans included the unreimbursed cost of Medicare, as recommended by the American Hospital Association, whereas others did not.
We tried to compare the economic values of the community benefits that tax-exempt hospitals provided with the income taxes they did not pay; however, the absence of complete and accurate data precluded a reliable and meaningful comparison. According to the tax board, it has not attempted to estimate the income taxes not collected from tax-exempt hospitals. Therefore, we estimated the uncollected taxes using the state corporation income tax rate and the economic values that tax-exempt hospitals assigned to the benefits they provided to their communities and reported in their plans in 2005. We used the reported values of these community benefits under the assumption that nonprofit hospitals use revenues that might otherwise be considered profits to provide community services. However, because tax-exempt hospitals reported their community benefits in an inconsistent manner, it was difficult to determine the community benefits that only tax-exempt hospitals might provide. Using our methodology, we estimated the income taxes not collected to be $58 million, but we cannot attest to the reliability of that estimate.
We also estimated the amount of property taxes not collected from tax-exempt hospitals, using the values of the buildings and contents owned by tax-exempt hospitals and reported to Equalization. Although we found numerous errors in the values that prevented us from ensuring the reliability of our calculation, this methodology resulted in an estimate of $184 million in uncollected property taxes in 2005. Combining the two estimates revealed that the economic value of the community benefits reported by the tax-exempt hospitals, which was about $656 million in 2005, was roughly 2.7 times the $242 million in income and property taxes not collected. However, more precise estimates based on complete and accurate data could produce a different result.
As we indicated previously, we found numerous errors in the amounts the county assessors submitted on statistical reports to Equalization. In fact, we found errors in the reported values for four of the 12 hospitals we reviewed, representing a total error of about $204 million. The errors for the remaining 211 nonprofit hospitals in the State that are eligible for tax exemption are unknown. Equalization performs surveys of county assessors to determine the adequacy of the procedures and practices they apply in valuing property for the purpose of taxation and for administering property tax exemptions. Including in these surveys a process for determining whether the county assessors are accurately reporting the values of tax-exempt properties on the annual statistical reports would be valuable.
The tax board, which administers state income tax exemptions, could improve its process of reviewing nonprofit hospitals to ensure their continued eligibility for the exemption. We found minor weaknesses in the process the tax board used in the past to determine the eligibility of nonprofit hospitals for income tax exemptions. However, legislation effective January 1, 2008, will allow the tax board to rely on the federal income tax exemptions determined by the Internal Revenue Service (IRS). Although it was unable to obtain IRS reports and other information on the federal review process and thus could not gain a full understanding of the method the IRS uses to determine eligibility for tax exemptions, the tax board contended that its research of the IRS Web site, publications, and tax law enabled it to conclude that the IRS process is sufficient to ensure proper determination of state exemption status. The tax board also stated that because state and federal laws on tax exemption are essentially identical, the additional audits it plans to perform—made possible by the workload reduction resulting from its use of IRS eligibility determinations—will compensate for any differences in quality between the state and federal review processes. The tax board indicated, however, that until it identifies the actual savings in workload that may occur when the new law is implemented, it cannot evaluate the opportunities for performing audits of nonprofit hospitals or plan for the number or frequency of such audits.
Moreover, the tax board does not use the tools available to it, such as annual filings and audits, to monitor the continuing eligibility of nonprofit hospitals for income tax exemption. According to management staff at the tax board, annual filings, which contain information such as financial data and changes in business activities, offer the tax board's Exempt Organizations Unit (unit) a useful tool for reviewing ongoing compliance with the requirements for maintaining tax-exempt status. However, the unit does not review the information in the annual filings. Rather, according to tax board management, the revenue information is recorded in the tax board's automated data system, and technicians review the forms only for class code errors and discrepancies in entities' names, numbers, or accounting periods. Management at the tax board stated that the large volume of initial applications for income tax exemptions and limited personnel prevent unit staff from reviewing the annual filings.
In the absence of monitoring by the tax board, hospitals exempt from income taxes sometimes submit annual filings that do not contain all the information required by the form or its instructions or information required under the California Code of Regulations (regulations). In our review of the most current annual filings of nine tax-exempt hospitals, we noted that three did not include the required schedules of other income, five did not include required depreciation schedules, and seven did not include the names and addresses of the five employees who received the highest annual compensation in excess of $30,000 and the amounts each received, although this information is required by the regulations. Moreover, we found that neither the form for the annual filing nor the instructions for completing the form covered all the information the tax board's regulations required. The tax board stated that it is not possible to include all the requirements of the regulations on the form or in the instructions for completing the form.
Regular auditing is another tool the tax board could use to monitor the tax-exempt status of nonprofit hospitals. However, the tax board does not regularly conduct audits of tax-exempt hospitals, even though, based on data provided by the tax board, the revenues of these hospitals represent 17 percent of the total revenue of all tax-exempt organizations. According to the tax board, an audit can originate when members of the public express concern that a tax-exempt organization may be functioning in a manner requiring revocation of its tax-exempt status. The tax board indicated, however, that it could not identify any complaints that might have prompted audits of tax-exempt hospitals, because it does not maintain a central record of the receipt or disposition of those complaints. Rather, complaints against tax-exempt organizations are stored in the tax board's paper files and cannot be easily retrieved.
The tax board stated that the revenue information from annual filings entered into its automated record-keeping system could be used to identify income-tax-exempt nonprofit hospitals to be considered for audit. However, because the tax board has not ensured that all tax-exempt nonprofit hospitals are distinctly identified in its electronic data system, it is unable to efficiently generate a list of the hospitals that might require audits. According to the tax board, creating such a list would necessitate manually reviewing the hard-copy files of the approximately 72,000 tax exempt organizations operating in the State to determine which are tax-exempt hospitals.
If the Legislature expects plans to contain comparable and consistent data, it should consider enacting statutory requirements that prescribe a mandatory format and methodology for tax-exempt nonprofit hospitals to follow when presenting community benefits in their plans.
If the Legislature intends that exemptions from income and property taxes granted to nonprofit hospitals should be based on hospitals providing a certain level of community benefits, it should consider amending state law to include such requirements.
To ensure that it provides accurate information regarding the value of property that is tax exempt, Equalization should consider including in its surveys of the county tax assessors a process for verifying the accuracy of the values reported on the annual statistical reports submitted by the county assessors.
After it identifies the staff resources that are no longer required for reviewing tax exemption applications, the tax board should implement its plan to use those resources for performing audits of tax-exempt entities, including hospitals.
The tax board should consider developing methodologies to monitor nonprofit hospitals' continuing eligibility for income tax exemption. These methodologies should include the following activities:
- Review the financial and other information from the annual filing submitted by hospitals exempt from income taxes.
- Ensure that the annual filing contains all the information the tax board's regulations specify as necessary for determining eligibility for an income tax exemption.
- Track complaints in a manner that enables the tax board to identify potential trends in noncompliance by income tax exempt hospitals and initiate audits of those hospitals.
- Adequately identify tax-exempt hospitals in its automated database, enabling it to use the information in the database to profile those hospitals and identify any potential noncompliance with the law.
Equalization and the tax board agree with our findings and state they have begun or will begin implementing our recommendations. Health Planning agrees with our findings, but provided added clarification regarding our description of uncompensated care costs.