United States: Five Lessons on Section 501(c)(3) from the Nonprofit Hospital Billing Litigation

In June 2004, an aggressive band of trial lawyers unleashed a wave of federal class action lawsuits on behalf of uninsured patients at hundreds of nonprofit hospitals. The lawyers made several claims based in federal and state law, but their crown jewel was an allegation that hospital billing and collection procedures were inconsistent with Section 501(c)(3) status. Using the federal tax-exemption laws, the lawyers sought to force changes in hospital practice and recover damages tied to the amount of the organizations’ purportedly ill-gotten tax savings.

At its root, the trial lawyers pushed an argument that:

• Section 501(c)(3) represents a contract between tax-exempt hospitals and the government, of which uninsured patients are third-party beneficiaries;
• the contract requires charity care for the uninsured, regulates prices, and prohibits certain collection practices;
• individual patients are entitled to enforce the contract; and
• as a remedy, tax-exempt hospitals should be forced to adopt new charity care, billing, and collection policies and pay over all or a portion of the value of their tax-exemptions.

This argument has been roundly rejected by every federal court to consider the issue. Though the large controversy is far from over, the federal cases have left behind several important lessons regarding the fundamentals of Section 501(c)(3).

In the vernacular, one often says the IRS "grants" tax-exempt status. But legally, this is not the case. The Internal Revenue Code, not the IRS, grants tax exemption to all "religious, charitable, scientific, testing for public safety, literary, or educational" organizations that meet the standards described in Section 501(c)(3). The IRS merely makes an administrative determination to recognize that an organization meets the standards. Section 501(c)(3) organizations (unlike other tax-exempt organizations) are not exempt unless they apply for recognition on Form 1023, but exemption does not depend on IRS consent. This is why an adverse IRS determination may be challenged in court, and why the IRS cannot alter the legal standards for exemption (such as by requiring, rather than strongly suggesting, a conflict of interest policy). Because the IRS does not grant tax-exempt status, it cannot be a part of any mutual contract with tax-exempt organizations.

Even if the IRS could be thought to grant tax-exempt status, the law is clear that statutes in general, and the tax law in particular, do not give rise to contractual rights absent a clear, contrary intent. The courts have now expressly applied this principle to Section 501(c)(3) and found no evidence to suggest a contract that the trial lawyers could enforce.

Even if Section 501(c)(3) created a contract between the IRS and tax-exempt entities, that does not mean trial lawyers can enforce it through litigation. Private enforcement could open up nonprofits to numerous challenges to their tax-exempt status, even where the IRS has determined that an organization meets the standards of Section 501(c)(3). Federal courts have now confirmed that the IRS is the exclusive enforcer of federal tax-exemption standards.

Ordinarily, organizations that fail to qualify under Section 501(c)(3) must thenceforth pay income taxes. But the trial lawyers sought to force tax-exempt hospitals to comply with Section 501(c)(3) and pay over previously foregone taxes, not to the IRS, but to them. Federal courts have rejected this argument and reconfirmed that the remedy for violating the standards for taxexemption remains assessment and collection of taxes by the IRS.

Apart from the procedural defects, many federal courts addressed the substance of the trial lawyers’ claims—that nonprofit hospitals are required to provide certain levels of charity care in order to qualify for exemption under Section 501(c)(3). Since 1969, the "community benefit standard" has dictated that charity care, though important, is only one of many factors considered in determining tax-exempt status. The federal courts have now explicitly rejected the notion that the failure to provide a minimum level of charity care, without any consideration regarding other factors supporting exemption, is a basis for revoking a hospital’s Section 501(c)(3) status.

Of all the lessons from the nonprofit hospital billing litigation, this is the one most vulnerable to change. In the early 1990s, Congress considered but declined to adopt a charity care requirement for Section 501(c)(3) hospitals. In the current environment, the proposal has found new traction. In July 2006, Senate Finance Committee Chairman Charles Grassley called for new IRS guidelines regulating levels of charity care and other billing and collection practices. Whether the IRS will issue such guidelines, and whether such guidelines will require any minimum amount of charity care, remains to be seen.

The failure of trial lawyers to successfully attack the Section 501(c)(3) status of nonprofit hospitals is by no means the end to the legal and regulatory wrangling over hospital billing and collection practices and care for the uninsured. Indeed, lawsuits are shifting to state court, with claims based on state tax exemptions and statues prohibiting unfair or deceptive trade practices. State attorneys general, as overseers of charitable institutions, are also becoming increasingly interested. And the larger public policy questions surrounding charity care and the uninsured are still hot topics in Congress, state legislatures, and think tanks. These developments notwithstanding, the unsuccessful federal litigation has clarified some important points regarding Section 501(c)(3).