IRS Revenue Ruling
1997-21

Code Sec. 501

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26 CFR 1.501(c)(3)-1: Organizations organized and operated for religious,
charitable, scientific, testing for public safety, literary, or
educational purposes, or for the prevention of cruelty to children or
animals.

Tax consequences of physician recruitment incentives provided by
hospitals described in section 501(c)(3) of the Code. This ruling provides
examples illustrating whether nonprofit hospitals that provide incentives
to physicians to join their medical staffs or to provide medical services
in the community violate the requirements for exemption as organizations
described in section 501(c)(3) of the Code.


REV. RUL. 97-21


ISSUE

Whether, under the facts described below, a hospital violates the
requirements for exemption from federal income tax as an organization
described in section 501(c)(3) of the Internal Revenue Code when it
provides incentives to recruit private practice physicians to join its
medical staff or to provide medical services in the community.


FACTS

All of the hospitals in the situations described below have been
recognized as exempt from federal income tax under section 501(a) as
organizations described in section 501(c)(3) and operate in accordance
with the standards for exemption set forth in Revenue Ruling 69-545,
1969-2 C.B. 117. The physicians described in the following recruiting
transactions do not have substantial influence over the affairs of the
hospitals that are recruiting them. Therefore, they are not disqualified
persons as defined in section 4958, nor do they have any personal or
private interest in the activities of the organizations that would subject
them to the inurement proscription of section 501(c)(3). Furthermore, in
Situations 1, 2, and 4, the physicians have no pre-existing relationship
with the hospital or the members of its board. For purposes of this
revenue ruling, the physician recruiting activities described in
Situations 1, 2, 3, and 4 are assumed to be lawful. However, because the
Internal Revenue Service does not have jurisdiction regarding whether the
activities described in Situations 1, 2, 3, and 4 are lawful under the
Medicare and Medicaid anti-kickback statute, 42 U.S.C. section
1320a-7b(b), taxpayers may not rely upon the facts or assumptions
described in this ruling for purposes relating to that statute.


SITUATION 1

Hospital A is located in County V, a rural area, and is the only
hospital within a 100 mile radius. County V has been designated by the
U.S. Public Health Service as a Health Professional Shortage Area for
primary medical care professionals (a category that includes obstetricians
and gynecologists). Physician M recently completed an ob/gyn residency and
is not on Hospital A's medical staff. Hospital A recruits Physician M to
establish and maintain a full-time private ob/gyn practice in its service
area and become a member of its medical staff. Hospital A provides
Physician in a recruitment incentive package pursuant to a written
agreement negotiated at arm's-length. The agreement is in accordance with
guidelines for physician recruitment that Hospital A's Board of Directors
establishes, monitors, and reviews regularly to ensure that recruiting
practices are consistent with Hospital A's exempt purposes. The agreement
was approved by the committee appointed by Hospital A's Board of Directors
to approve contracts with hospital medical staff. Hospital A does not
provide any recruiting incentives to Physician M other than those set
forth in the written agreement.

In accordance with the agreement, Hospital A pays Physician in a
signing bonus, Physician M's professional liability insurance premium for
a limited period, provides office space in a building owned by Hospital A
for a limited number of years at a below market rent (after which the
rental will be at fair market value), and guarantees Physician M's
mortgage on a residence in County V. Hospital A also lends Physician M
practice start-up financial assistance pursuant to an agreement that is
properly documented and bears reasonable terms.


SITUATION 2

Hospital B is located in an economically depressed inner-city area of
City W. Hospital B has conducted a community needs assessment that
indicates both a shortage of pediatricians in Hospital B's service area
and difficulties Medicaid patients are having obtaining pediatric
services. Physician N is a pediatrician currently practicing outside of
Hospital B's service area and is not on Hospital B's medical staff.
Hospital B recruits Physician N to relocate to City W, establish and
maintain a full-time pediatric practice in Hospital B's service area,
become a member of Hospital B's medical staff, and treat a reasonable
number of Medicaid patients. Hospital B offers Physician N a recruitment
incentive package pursuant to a written agreement negotiated at
arm's-length and approved by Hospital B's Board of Directors. Hospital B
does not provide any recruiting incentives to Physician N other than those
set forth in the written agreement.

Under the agreement, Hospital B reimburses Physician N for moving
expenses as defined in section 217(b), reimburses Physician N for
professional liability "tail" coverage for Physician N's former practice,
and guarantees Physician N's private practice income for a limited number
of years. The private practice income guarantee, which is properly
documented, provides that Hospital B will make up the difference to the
extent Physician N practices full-time in its service area and the private
practice does not generate a certain level of net income (after reasonable
expenses of the practice). The amount guaranteed falls within the range
reflected in regional or national surveys regarding income earned by
physicians in the same specialty.


SITUATION 3

Hospital C is located in an economically depressed inner city area of
City X. Hospital C has conducted a community needs assessment that
indicates indigent patients are having difficulty getting access to care
because of a shortage of obstetricians in Hospital C's service area
willing to treat Medicaid and charity care patients. Hospital C recruits
Physician O, an obstetrician who is currently a member of Hospital C's
medical staff, to provide these services and enters into a written
agreement with Physician O. The agreement is in accordance with guidelines
for physician recruitment that Hospital C's Board of Directors
establishes, monitors, and reviews regularly to ensure that recruiting
practices are consistent with Hospital C's exempt purpose. The agreement
was approved by the officer designated by Hospital C's Board of Directors
to enter into contracts with hospital medical staff. Hospital C does not
provide any recruiting incentives to Physician O other than those set
forth in the written agreement. Pursuant to the agreement, Hospital C
agrees to reimburse Physician O for the cost of one year's professional
liability insurance in return for an agreement by Physician O to treat a
reasonable number of Medicaid and charity care patients for that year.


SITUATION 4

Hospital D is located in City Y, a medium to large size metropolitan
area. Hospital D requires a minimum of four diagnostic radiologists to
ensure adequate coverage and a high quality of care for its radiology
department. Two of the four diagnostic radiologists currently providing
coverage for Hospital D are relocating to other areas. Hospital D
initiates a search for diagnostic radiologists and determines that one of
the two most qualified candidates is Physician P.

Physician P currently is practicing in City Y as a member of the
medical staff of Hospital E (which is also located in City Y). As a
diagnostic radiologist, Physician P provides services for patients
receiving care at Hospital E, but does not refer patients to Hospital E or
any other hospital in City Y. Physician P is not on Hospital D's medical
staff. Hospital D recruits Physician P to join its medical staff and to
provide coverage for its radiology department. Hospital D offers Physician
P a recruitment incentive package pursuant to a written agreement,
negotiated at arm's-length and approved by Hospital D's Board of
Directors. Hospital D does not provide any recruiting incentives to
Physician P other than those set forth in the written agreement.

Pursuant to the agreement, Hospital D guarantees Physician P's private
practice income for the first few years that Physician P is a member of
its medical staff and provides coverage for its radiology department. The
private practice income guarantee, which is properly documented, provides
that Hospital D will make up the difference to Physician P to the extent
the private practice does not generate a certain level of net income
(after reasonable expenses of the practice). The net income amount
guaranteed falls within the range reflected in regional or national
surveys regarding income earned by physicians in the same specialty.


SITUATION 5

Hospital F is located in City Z, a medium to large size metropolitan
area. Because of its physician recruitment practices, Hospital F has been
found guilty in a court of law of knowingly and willfully violating the
Medicare and Medicaid anti-kickback statute, 42 U.S.C. section
1320a-7b(b), for providing recruitment incentives that constituted
payments for referrals. The activities resulting in the violations were
substantial.


LAW

Section 501(c)(3) provides, in part, for the exemption from federal
income tax of corporations organized and operated exclusively for
charitable, scientific, or educational purposes, provided no part of the
organization's net earnings inures to the benefit of any private
shareholder or individual.

Section 1.501(c)(3F1(d)(2) of the Income Tax Regulations provides that
the term "charitable" is used in section 501(c)(3) in its generally
accepted legal sense. The promotion of health has long been recognized as
a charitable purpose. See Restatement (Second) of Trusts, sections 368,
372 (1959); 4A Austin W. Scott and William F. Fratcher, The Law of Trusts
sections 368, 372 (4th ed. 1989); and Rev. Rul. 69-545, 1969-2 C.B. 117.
Under the common law of charitable trusts, all such organizations are
subject to the requirement that their purposes may not be illegal. See
Restatement (Second) of Trusts section 377 (1959); 4A Austin W. Scott and
William F. Fratcher, The Law of Trusts section 377 (4th ed. 1989); Bob
Jones University v. U.S., 461 U.S. 574, 591 (1983); Rev. Rul. 80-278,
1980-2 C.B. 175; Rev. Rul. 80-279, 1980-2 C.B. 176.

Section 1.501(c)(3)-1(c)(2) states that an organization is not operated
exclusively for charitable purposes if its net earnings inure in whole or
in part to the benefit of private shareholders or individuals.

Section 1.501(a)-1(c) defines "private shareholder or individual" as
referring to persons having a personal and private interest in the
activities of the organization.

Section 1.501(c)(3)-1(d)(1)(ii) states that an organization is not
organized exclusively for any of the purposes specified in section
501(c)(3) unless it serves public, rather than private interests. Thus, an
organization applying for tax exemption under section 501(c)(3) must
establish that it is not organized or operated for the benefit of private
interests.

Rev. Rul. 69-545, 1969-2 C.B. 117, holds that a non-profit hospital
that benefits a broad cross section of its community by having an open
medical staff and a board of trustees broadly representative of the
community, operating a full-time emergency room open to all regardless of
ability to pay, and otherwise admitting all patients able to pay (either
themselves, or through third party payers such as private health insurance
or government programs such as Medicare) may qualify as an organization
described in section 501(c)(3). The same standard has been used by the
courts as the basis for evaluating whether health maintenance
organizations qualify for exemption as organizations described in section
501(c)(3). Sound Health Association v. Commissioner, 71 T.C. 158 (1978),
acq. 1981-2 C.B. 2; Geisinger Health Plan v. Commissioner, 985 F.2d 1210
(3rd Cir. 1993), rev'g 62 T.C.M. (CCH) 1656 (1991).

Rev. Rul. 72-559, 1972-2 C.B. 247, holds that an organization that
provides subsidies to recent law school graduates during the first three
years of their practice to enable them to establish legal practices in
economically depressed communities that have a shortage of available legal
services and to provide free legal service to needy members of the
community may qualify as an organization described in section 501(c)(3).

Rev. Rul. 73-313, 1973-2 C.B. 174, holds that attracting a physician to
a community that had no available medical services furthered the
charitable purpose of promoting the health of the community. In Rev. Rul.
73-313, residents of an isolated rural community had to travel a
considerable distance to obtain care. Faced with the total lack of local
services, the community formed an organization to raise funds and build a
medical office building to attract a doctor to the locality. (No hospitals
or existing medical practices were involved.) The ruling states that
certain facts are particularly relevant: (1) the demonstrated need for a
physician to avert a real and substantial threat to the community; (2)
evidence that the lack of a suitable office had impeded efforts to attract
a physician; (3) the arrangements were completely at arm's-length; and (4)
there was no relationship between any person connected with the
organization and the recruited physician. The ruling states that, under
all the circumstances, the arrangement used to induce the doctor to locate
a practice in the area "bear[s] a reasonable relationship to promotion and
protection of the health of the community" and any private benefit to the
physician is incidental to the public purpose achieved. It concludes that
the activity furthers a charitable purpose and the organization qualifies
for exemption as an organization described in section 501(c)(3).

Rev. Rul. 75-384, 1975-2 C.B. 204, holds that an organization whose
primary activity is sponsoring antiwar protest demonstrations in which
demonstrators are urged to commit violations of local ordinances and
breaches of the public order does not qualify as an organization described
in section 501(c)(3) because its activities demonstrate an illegal purpose
that is inconsistent with charitable purposes.

Rev. Rul. 80-278, 1980-2 C.B. 175, and Rev. Rul. 80-279, 1980-2 C.B.
176, discuss the qualification as organizations described in section
501(c)(3) of organizations that conduct environmental litigation and
environmental dispute mediation. In holding that these organizations may
qualify, the rulings state that, in determining whether an organization
meets the operational test, the issue is whether the particular activity
undertaken by the organization appropriately furthers the organization's
exempt purpose. The rulings state that an organization's activities will
be considered permissible under section 501(c)(3) if the following
conditions are met: (1) the purpose of the organization is charitable; (2)
the activities are not illegal, contrary to a clearly defined and
established public policy, or in conflict with express statutory
restrictions; and (3) the activities are in furtherance of the
organization's exempt purpose and are reasonably related to the
accomplishment of that purpose.


ANALYSIS

In order to meet the requirements of section 501(c)(3), a hospital that
provides recruitment incentives to physicians must provide those
incentives in a manner that does not cause the organization to violate the
operational test of section 1.501(c)(3)-1. Whether the recruitment
incentives cause the organization to violate the operational test is
determined based on all relevant facts and circumstances. When a section
501(c)(3) hospital recruits a physician for its medical staff who is to
perform services for or on behalf of the organization, the organization
meets the operational test by showing that, taking into account all of the
benefits provided the physician by the organization, the organization is
paying reasonable compensation for the services the physician is providing
in return. A somewhat different analysis must be applied when a section
501(c)(3) hospital recruits a physician for its medical staff to provide
services to members of the surrounding community but not necessarily for
or on behalf of the organization. In these cases, a violation will result
from a failure to comply with any of the following four requirements:

First, the organization may not engage in substantial activities that
do not further the hospital's exempt purposes or that do not bear a
reasonable relationship to the accomplishment of those purposes. As
discussed in Rev. Rul. 80-278 and Rev. Rul. 80-279, in determining whether
an organization meets the operational test, the issue is whether the
particular activity undertaken by the organization is appropriately in
furtherance of the organization's exempt purpose.

Second, the organization must not engage in activities that result in
inurement of the hospital's net earnings to a private shareholder or
individual. An activity may result in inurement if it is structured as a
device to distribute the net earnings of the hospital. See Lorain Avenue
Clinic v. Commissioner, 31 T.C. 141 (1958); Birmingham Business College,
Inc. v. Commissioner, 276 F.2d 476 (5th Cir. 1960).

Third, the organization may not engage in substantial activities that
cause the hospital to be operated for the benefit of a private interest
rather than public interest so that it has a substantial non-exempt
purpose. Section 1.501(c)(3)-1(d)(1)(ii).

Finally, the organization may not engage in substantial unlawful
activities. As discussed in Rev. Rul. 75-384, Rev. Rul. 80-278, and Rev.
Rul. 80-279, the conduct of an unlawful activity is inconsistent with
charitable purposes. An organization conducts an activity that is
unlawful, and therefore not in furtherance of a charitable purpose, if the
organization's property is to be used for an objective that is in
violation of the criminal law. Activities can accomplish an unlawful
purpose through either direct or indirect means.


SITUATION 1

Like the organization described in Rev. Rul. 73-313, Hospital A has
objective evidence demonstrating a need for obstetricians and
gynecologists in its service area and has engaged in physician recruitment
activity bearing a reasonable relationship to promoting and protecting the
health of the community in accordance with Rev. Rul. 69-545. As with the
subsidies provided to the recent law school graduates in Rev. Rul. 72-559,
the payment of a bonus, the guarantee of a mortgage, the reimbursement of
professional liability insurance and provision of subsidized office space
for a limited time, and the lending of start-up financial assistance as
recruitment incentives are reasonably related to causing Physician M to
become a member of Hospital A's medical staff and to establish and
maintain a full-time private ob/gyn practice in Hospital A's service area.
The provision of the incentives under the circumstances described furthers
the charitable purposes served by the hospital and is consistent with the
requirements for exemption as an organization described in section
501(c)(3).


SITUATION 2

Like Hospital A in Situation 1, Hospital B has objective evidence
demonstrating a need for pediatricians in its service area and has engaged
in physician recruitment activity bearing a reasonable relationship to
promoting and protecting the health of the community in much the same
manner as the organization described in Rev. Rul. 73-313. As with the
recruitment incentive package provided by Hospital A, the payment of
moving expenses, the reimbursement of professional liability "tail"
coverage, and the provision of a reasonable private practice income
guarantee as recruitment incentives are reasonably related to causing
Physician N to become a member of Hospital B's medical staff and to
establish and maintain a full-time private pediatric practice in Hospital
B's service area. Thus, the recruitment activity described furthers the
charitable purposes served by the hospital and is consistent with the
requirements for exemption as an organization described in section
501(c)(3).


SITUATION 3

In accordance with the standards for exemption set forth in Rev. Rul.
69-545, Hospital C admits and treats Medicaid patients on a
non-discriminatory basis. Hospital C has identified a shortage of
obstetricians willing to treat Medicaid patients. The payment of Physician
O's professional liability insurance premiums in return for Physician O's
agreement to treat a reasonable number of Medicaid and charity care
patients is reasonably related to the accomplishment of Hospital C's
exempt purposes. Because the amount paid by Hospital C is reasonable and
any private benefit to Physician O is outweighed by the public purpose
served by the agreement, the recruitment activity described is consistent
with the requirements for exemption as an organization described in
section 501(c)(3).


SITUATION 4

Hospital D has objective evidence demonstrating a need for diagnostic
radiologists to provide coverage for its radiology department so that it
can promote the health of the community. The provision of a reasonable
private practice income guarantee as a recruitment incentive that is
conditioned upon Physician P obtaining medical staff privileges and
providing coverage for the radiology department is reasonably related to
the accomplishment of the charitable purposes served by the hospital. A
significant fact in determining that the community benefit provided by the
activity outweighs the private benefit provided to Physician P is the
determination by the Board of Directors of Hospital D that it needs
additional diagnostic radiologists to provide adequate coverage and to
ensure a high quality of medical care. The recruitment activity described
is consistent with the requirements for exemption as an organization
described in section 501(c)(3).


SITUATION 5

Hospital F has engaged in physician recruiting practices resulting in a
criminal conviction. As in Rev. Rul. 75-384, the recruiting activities
were intentional and criminal, not isolated or inadvertent violations of a
regulatory statute. An organization that engages in substantial unlawful
activities, including activities involving the use of the organization's
property for an objective that is in violation of criminal law, does not
qualify as an organization described in section 501(c)(3). Because
Hospital F has knowingly and willfully conducted substantial activities
that are inconsistent with charitable purposes, it does not comply with
the requirements of section 501(c)(3) and section 1.501(c)(3)-1.


HOLDING

The hospitals in Situations 1, 2, 3, and 4 have not violated the
requirements for exemption from federal income tax as organizations
described in section 501(c)(3) as a result of the physician recruitment
incentive agreements they have made because the transactions further
charitable purposes, do not result in inurement, do not result in the
hospitals serving a private rather than a public purpose, and are assumed
to be lawful for purposes of this revenue ruling.

Hospital F in Situation 5 does not qualify as an organization described
in section 501(c)(3) because its unlawful physician recruitment activities
are inconsistent with charitable purposes.


SCOPE

This ruling addresses only issues under section 501(c)(3) in the
described situations. No inference is intended as to any other issue under
any other provision of law, including any issue involving worker
classification, income tax consequences to the physicians, and application
of the Medicare and Medicaid anti-kickback statute, 42 U.S.C. section
1320a-7b(b).


DRAFTING INFORMATION

The principal author of this revenue ruling is Judith E. Kindell of the
Exempt Organizations Division. For further information regarding this
revenue ruling contact Judith E. Kindell on (202) 622-6494 (not a
toll-free call).

<<END RULING>>
 

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