American College of Physicians: Internal Medicine — Doctors for Adults ®

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Five ways to avoid nonprofit troubles with the IRS

How to recognize financial dealings with nonprofit organizations that can get you in trouble

From the June 1997 ACP Observer, copyright 1997 by the American College of Physicians.

By Thomas P. Frank, CPA

Physicians who have financial relationships with nonprofit hospitals and health networks have a few more IRS regulations to worry about.

Through the Taxpayers Bill of Rights Act 2, which took effect July 30, 1996, the IRS can fine hospitals and health networks that try to buy referrals from physicians by overpaying physicians for their practices or offering physicians excessively generous compensation packages. (Previously, the IRS's primary sanction was withdrawing the organization's tax-exempt status.) The law also regulates nonprofit hospitals and health systems that directly employ physicians, fund independent physician associations and physician-hospital organizations (PHOs) with physicians and contract with physicians for outpatient and other related services.

However, physicians may also be penalized if they look like they've reaped rewards from others' violations—even if the physicians weren't aware they were breaking the law.

To stay out of harm's way, physicians need to understand the law, know what questions to ask, and retain sound financial and legal counsel. Here are five rules of thumb to follow when entering financial arrangements with a nonprofit hospital or health system.

1. Know who is liable. The law applies when nonprofit hospitals or health systems engage in financial transactions that excessively benefit a private individual, defined as "excess benefit transactions." It is important to realize, however, that the organization is not the only one subject to fines. Rather, the individual who exercises substantial influence over the organization—defined by the law as an "organization manager" or "disqualified person"—is subject to the tax.

Organization managers include a physician who admits a large number of patients to a hospital as well as any officer, director, trustee or other individuals who have similar powers or responsibilities. Organization managers—this category typically includes physicians who are directly employed by the hospital or network—can be penalized only if they authorize the transaction and know that it is improper.

Disqualified persons are those in a position to exercise "substantial influence" over the organization because they serve as organization managers. These individuals involved in an excess benefit transaction—private physicians who refer a large number of patients, for example—are automatically subject to IRS sanctions, even if they did not know the transaction was illegal.

2. Know which transactions are covered by the law. The IRS regulations target transactions where the economic benefit-the purchase price of a practice, for example—exceeds the fair market value. This includes disqualified individuals who receive excessive compensation from the organization or receive payment based on the organization's revenues in a manner that gives them excess benefit.

The law also applies when nonprofit hospitals or networks enter into a joint venture with physicians who get financial rewards from the arrangement without taking any financial risk. A good example is a PHO in which physicians are given a stake in the organization's profits without investing any of their own money. This type of arrangement is usually offered to encourage physicians to refer their patients to the organization.

3. Make sure you receive fair market value when selling your practice. To know what constitutes fair market value for your practice, get an independent appraisal from an accounting firm that specializes in valuing medical practices.

The firm should be knowledgeable about IRS guidelines on the proper methodology to use in valuing a medical practice. The appraiser needs to understand the discounted cash flow method that the IRS requires, and not just the traditional method of valuing practices, which is typically based on gross income.

Under the discounted cash flow method, a practice that is expected to earn $1 million in profit over the next five may be worth less than that. Under IRS rules, a nonprofit hospital or network purchasing a physician practice must use a discount factor to determine what a practice's projected earnings make it worth in today's marketplace.

The key to a sound appraisal—one that won't be challenged by the IRS—is using the correct discount factor. To do that, appraisers need to understand what various specialties in medicine are worth in today's market.

In addition, nonprofit hospitals and health networks should conduct their own appraisals when purchasing a physician practice. This will help prove that the appraisal was sound in the event of an audit by the IRS.

4. Ensure that your employment contract is structured properly. Again, retain a knowledgeable attorney or accountant who understands the health care field when negotiating your salary and receiving any services or benefits from a hospital or health network.

If a deal sounds too good to be true, it probably is. Are you getting something for nothing? A salary that is much higher than is warranted? A free computer system or management advice? Purchase discounts on supplies? These circumstances are all covered under the law—and can leave you liable to sanctions.

5. Arrange for an ongoing assessment. At the time you sell your practice, you may receive a fair market value price. Over time, however, the terms of that original agreement might need to be adjusted to reflect changes in the market.

When signing a contract to join a PHO, for example, a practice might be paying fair market prices for services such as office management. Over time, however, if the costs of those services rises and the contract is not renegotiated, physicians could actually be receiving management services from the PHO for less than market value, which would violate IRS regulations.

The best way to avoid this kind of excess benefit transaction is to arrange for an operational audit. Every few years after you sell a practice, have a qualified financial consultant conduct an assessment to ensure that all financial arrangements are within the law.

Thomas Frank is a certified public accountant and a partner with The Abrix Group, L.P., based in Northbrook, Ill. He specializes in physician integration and compensation, pension and retirement planning.

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