In this episode, Michael Peregrine, Partner at McDermott, Will & Emery discusses the new reality that tax-exempt organizations, especially hospitals and health systems, face under our new tax reform law.
Mike Passanante: Hi, this is Mike Passanante. And welcome back to the Hospital Finance Podcast.
Tax-exempt organizations, especially hospitals and health systems face a new tax reality under our new tax reform law. To clarify the impact on these entities, I’m joined by Michael Peregrine, a partner in the Chicago office of McDermott Will and Emery.
Michael represents corporations and their officers and directors in connection with governance, corporate structure, fiduciary duties, officer director liability issues, charitable trust law, and corporate alliances. Michael is recognized as one of the leading national practitioners in corporate governance law.
Michael, welcome to the podcast!
Michael Peregrine: Thank you, Mike. Glad to be with you all.
Mike Passanante: So, Michael, your firm recently published an article that looked at the impact of the new tax law. And I’d like to just walk through a few of the key points that you made in there, and have you break those down for us.
So first, the country’s largest tax-exempt organizations will now find it more costly to recruit and retain their top talent. Tell us about that.
Michael Peregrine: Well, I think the underlying issue here as many of your listeners are already aware is that the new tax act incorporated an annual excise tax on compensation of non-profits that exceeds a million dollars paid to any of the covered employees (and that’s a defined term). And obviously, there’s going to be a lot of technical issues that will be worked out by the IRS in terms of proposed regulations on how this will actually work.
But the hidden jab to the non-profit tax-exempt healthcare sector is that while this excise tax was intended to place the exempt organizations on a par with publicly-held companies as it relates to the deductibility of high compensation amounts, they’re actually in a competitive disadvantage to the private non-publicly traded companies. Tax-exempts have to pay a 21% tax surcharge, this new excise tax for comparable salaries, for comparable positions. But the private companies that are getting into healthcare on a very regular basis don’t.
So, while we may be on the par with the publicly traded companies, we are absolutely at a competitive disadvantage because we need to pay this excise tax, and they do not.
And so, when we’re talking about a finance team, working with the board to identify what the compensation for a senior manager should be, and you’re taking into consideration this 21% excise tax, you have to figure out how does the cost of this tax work into our financial structure. That’s one issue. How do we pay this? Where do we locate these executives? And what efforts can we take to reduce the tax?
But the other issue is when we’re out there recruiting and retaining high quality competent executives, we need to be mindful that we are competing on an uneven playing field with the private companies. And again, as I’ve said, we all know they’re getting into healthcare on a very regular basis. They don’t have to pay this tax!
And this is one of the issues where I think that Congress, we knew what they were doing with respect to the level playing field, but it doesn’t look like they really figured out that they were actually putting the non-profit sector at a disadvantage. The question will ultimately be “Do they care? Will this get fixed?” And I don’t think we can count on that.
Mike Passanante: So, the next point that you made in the article was that advanced refunding bonds have been repealed, but tax-free bond financing otherwise remains available for Section 501c3 organizations. Can you break that down for us?
Michael Peregrine: Well, one of the things that I think came out of the blue in December when all these stuff was coming together was the effort to eliminate taxes and bond financing for 501c3 organizations. And many of your listeners followed the evolution of the tax act very closely. And ultimately, what happened was that advanced refunding bonds have been repealed, but tax-free bond financing otherwise remains available.
So, we know again advanced refunding bonds eliminated what was left. Existing bonds will still be able to be refinanced provided that they’re callable at the time of refunding. What was eliminated by the act are only refundings where the bonds are not yet callable at the desired date of the refunding.
Like so many other aspects of the tax act, Mike, we want to take a step back and ask ourselves a question: “Where is this headed? Why did this arise in the first place? What did the law maker, the tax directors and Congress have against taxes and bond financing?”
And so, in terms of projecting forward capital planning in the future, obviously, many people listening into this podcast, if they are finance executive at tax-exempt organization, are going to be looking towards other access vehicles to capital. Are we looking at taxable financing? Are we looking at investments from private companies? How are we accessing the capital? Is the tax-exempt bond market a real long-term viable option?
And I think that’s what’s going on right now because, again, this came out of the blue. What was the basis for this attack? And is this just the beginning? Will ultimately all tax-free bond financing be eliminated?
I think that is the concern for healthcare finance managers. Where is this going? And should we now be hedging our bet, so to speak, by exploring capital financing alternatives in a taxable market?
Mike Passanante: You also noted that tax-exempt organizations with unrelated businesses may owe additional tax. What does that mean?
Michael Peregrine: Well, the UBIT has always been the accountants dream in terms of the question what is and what is not unrelated business income. It’s always been a thorny topic. It is even a more thorny topic now as the nature of healthcare changes and patient hospitals are on decline in terms of their utility and healthcare systems are getting into different types of delivery of care. So what is related to the charitable purpose or the non-profit purpose of the healthcare system is a moving target right now.
The UBIT laws have always been designed to basically even the playing field where tax-exempt organizations are competing with for profit tax-paying organizations in activities that are outside of their charitable purposes. You pay their unrelated. You pay a tax on that.
In the past, a tax-exempt organization could aggregate and roll up all the profits and losses with all its various unrelated businesses and pay tax only on the resulting income. That’s not going to be allowable going forward. Losses from one activity aren’t going to be allowed to offset profits from the other. So you’re going to see a siloing of unrelated business activities.
And the tax professionals and the accountants will tell you “figuring that out ain’t so easy.” The underlying issue here I think, Mike, is the question of: “What is, on a going forward basis, related versus unrelated? Where does one activity end and another beginning, especially with respect to expense allocation?”
Bottom line—again, big picture—the issue of unrelated business income taxation and the issue of what is an unrelated business activity now becomes an important tax-planning and finance issue. And this hasn’t been the case for a long time.
In the old days, back when I started practicing healthcare law, there was a significant concern where the IRS was enforcing the UBIT laws vigorously. And there was some concern that too much unrelated business activity could actually jeopardize your tax exemption.
We’re getting back into that venue now. We’re not worried per se about too much UBIT jeopardizing the exemption, but we’re talking about a greater focus on the question of what is related activity and what is unrelated activity because, again, the UBIT rules are now being broadened to encompass or capture more of that activity.
Mike Passanante: And you mentioned in the article that exempt organization leadership should be prepared with proactive defenses of their exempt operations.
Michael Peregrine: Mike, I really do believe that that is the ultimate takeaway for healthcare finance executives from the tax bill last December. It’s certainly important to look at all the provisions that actually made it into the act in late December. But it’s more important I think—not only for the executives, but for the board members too—to look at the big picture, “What was going on here?”
In many respects, the real story is not what made it into the act, but what was left on the sideline. But you had the spectre of both the House Ways & Means Committee and the Senate Finance Committee, the two major tax-writing arms of Congress both introducing multiple sets of provisions that were highly punitive to tax-exempt organizations.
Many of them didn’t make it to the final bill. For example, there was a proposal that went pretty far. They would’ve removed the rebuttal presumption of reasonableness on which most tax-exempt healthcare executive compensation arrangements are based upon.
So, the real question is…why? What’s going on? Where did this come from? And you can say it was a revenue-generating device. But there was clearly some kind of concern, bias, worry in Congress that large tax-exempt organizations including large, regional and national healthcare systems were getting closer to the point where it was difficult to justify charitable status. They are so large that there are certain members of the tax-writing committees in Congress who felt are we good stewards of the public by extending these giant organizations special tax exemptions. And while we’re not going to take away 501c3 totally, maybe we’re going to whittle it down in areas where we can like we’ve talked about. We’re going to target some of the areas where we’re particularly concerned—executive compensation, advance refunding bonds, UBIT, things of that nature.
So, the real question I think for boards and executive leadership is: Why are they mad at us? What are the elements of the way we conduct our businesses that they’re concerned about? And most importantly, how can we demonstrate that we in a tax-exempt hospital and healthcare sector are different than our colleagues, our peers, and the for profit public company, private company sector.
And this means I think a concentrated effort in a couple of ways. The board and executive leadership needs to spend more time I think talking what is the elevator story. What is it that we do as an institution, as a system, that’s worthy of tax exemption? How are we different than our for profit counterparts? What do we do with respect to our individual decisions and collectively that is worthy of tax exempt protection—and to be able to say that on a regular basis, to be able to communicate that at all levels so that healthcare consumers and their elected representatives and the IRS understand that there is a distinction between the delivery of care in a tax-exempt model and a taxable model and what those distinctions are.
At the same time, it’s important for these organizations to ramp up their compliance activities with respect to the special tax provisions that relate to charity care and relate to community benefit which have been on the tax loss for a number of years and where the IRS—this is the 501r provision as many folks know. The IRS is very focused on this. Senator Grafstein and Senator Hatch had been pushing this as well. As a compliance matter, it’s very important that the tax-exempt industry in healthcare is up-to-date with respect to 501r compliance because it’s the practical side of the tax exemption coin. That is the specific section of the tax code that Congress enacted a few years ago to make sure hospitals were providing a charitable service.
But the other side of the coin is the broader policy focus. What are we doing to merit tax exemption? And I think in many respects, while the individual aspects of the tax act are very important to be knowledgeable about, the higher purpose, the greater policy of boards and exempt hospital leadership is we need to make our case, and we need to do it quickly and comprehensively and persuasively, or we’re going to be looking at additional congressional efforts to cut back tax exemptions in the near future.
Mike Passanante: Michael, do you have any parting advice for hospitals?
Michael Peregrine: I think that the concept of tax planning now takes on an entirely new focus not only in the compliance area, but also with respect to the Office of the General Council and Board Executive Leadership. It now becomes a more major issue when—
I think we all acknowledge that over the last five to seven years, the IRS-exempt organization function has been less active publicly. But now, over the last year and a half, you’ve seen two hospital tax-exemption revocation actions even though, in unusual circumstances, there are still two revocations when, in prior years, there haven’t been any.
So, all of a sudden, tax planning and the choice of entity and how we justify our tax exemption and how we choose to engage in new ventures becomes an issue when it hasn’t been in the past.
So, for the finance executives, for operational executives, for strategic planning executives and for board leaders, you’ve got to add tax planning back into the equation where, frankly, it hasn’t been that important in years past.
Mike Passanante: And Michael, if someone wanted to read more insights from you or learn more about your organization, where can they go?
Michael Peregrine: Just come to the website at McDermott Will and Emery, hit the icon called McDermott’s Take on the Tax Act, and that’ll get you all the details you need.
I think the other thing to monitor, Mike, is where the IRS goes in this. They’re just beginning to tackle the development of guidance on the exempt organization provision of the tax act. So I’m sure all of you, the folks listening, are home subscribers to the various tax publications and are avid readers of the changes in the Exempt Organization Tax Law. But in all seriousness, I think it’s to monitor over the next year what the IRS does with respect to regulations intended to implement these laws as you and I have been talking about today.
Mike Passanante: Michael Peregrine, thanks so much for joining us today on the Hospital Finance Podcast.
Michael Peregrine: Thank you, Mike.