On November 9, 2017, Republicans on the Senate Finance Committee announced their plan for reforming the Federal tax code, including several provisions that target charitable hospitals and other tax-exempt organizations. Like the House proposal announced the week before, the Senate plan calls for a 20 percent excise tax on certain compensation arrangements in excess of $1 million, imposes a 1.4 percent excise tax on college endowments, eliminates advance refunding bonds, and limits net operating losses to 90 percent of taxable income. Unlike the House tax plan, however, the Senate proposal safeguards private activity bonds, preserving a valuable financing resource used by most charitable hospitals, and it contains several additional provisions that would significantly affect the governance and operation of charitable hospitals.

The Senate’s additional proposals for charitable hospitals and other tax-exempt organizations include the following:

• Modifying the scope and application of intermediate sanctions under Internal Revenue Code section 4958;
• Treating royalty income earned by charitable hospitals and other-tax exempt organizations as unrelated business income; and
• Changing the way charitable hospitals and other tax-exempt organizations calculate unrelated business income.

Increasing Scope, Application of Intermediate Sanctions. The Senate proposal contains four changes that would expand the scope and application of intermediate sanctions under Internal Revenue Code section 4958. First, the Senate proposal eliminates the rebuttable presumption of reasonableness and transforms it into “minimum standards of due diligence.”  Second, charitable hospitals and certain other tax-exempt organizations would face a new ten-percent entity-level excise tax for participating in an excess benefit transaction. Third, board members and organization managers could face excise tax liability even if they relied on professional advice in approving compensation arrangements and other transactions that were determined to be inconsistent with fair market value. Finally, investment advisors would automatically be treated as disqualified persons for purposes of the intermediate sanctions provisions.

Under existing law, charitable hospitals and certain other tax- exempt organizations acquire a presumption that a compensation arrangement or other transaction is consistent with fair market value if (1) the compensation arrangement or other transaction is approved in advance by an authorized body composed of individuals who do not have a conflict of interest with respect to the arrangement or transaction, (2) the authorized body obtained and relied on appropriate data to demonstrate the reasonableness of the compensation or other transaction, and (3) the authorized body documented the basis for its determination concurrently with making its determination. If a charitable hospital follows these steps, the IRS must prove by sufficient contrary evidence that the compensation arrangement or other transaction was not consistent with fair market value.

The Senate proposal would eliminate the protection the rebuttable presumption provides by making these steps evidence of only “minimum standards of due diligence” with respect to the compensation arrangement or transaction.

The Senate proposal also increases the likelihood that charitable hospitals and certain other exempt organizations would face excise tax liability for participating in an excess benefit transaction. Currently, only disqualified persons who receive an excess benefit and organization managers who knowingly participate in the excess benefit face excise tax liability. The Senate proposal would create a new ten-percent entity-level excise tax that would apply if the charitable hospital did not satisfy the minimum standards of due diligence described above.

Directors and other organization managers also receive protection against excise tax liability under existing law if they rely on professional advice in making a decision with respect to a compensation arrangement or other transaction. The Senate proposes removing this protection and, instead, would consider reliance on professional advice as merely one factor in determining whether the director or other organization manager knowingly participated in the compensation arrangement or other transaction.

Finally, under the Senate proposal, disqualified persons would automatically include any person who receives compensation from the charitable hospital and who is primarily responsible for managing the investment of, or providing investment advice with respect to, the charitable hospital’s assets.

Subjecting Name and Logo Royalties to UBIT. The Senate proposal would impose the unrelated business income tax on revenue generated through name and logo royalties. Currently, the unrelated business income tax does not apply to royalty income earned by a charitable hospital.

Calculating UBIT Separately. The Senate proposal would also require charitable hospitals to calculate unrelated business income separately for each unrelated business activity. If adopted, charitable hospitals would not be able to offset income earned through one unrelated business activity against losses generated by another unrelated business activity. Additionally, net operating losses would only apply to the business from which the loss arose.

The Senate Finance Committee is scheduled to markup the tax plan beginning on November 13, 2017. A draft of the Chairman’s markup of the tax proposal is available here. House and Senate leaders have indicated they would like to pass federal tax reform within the next ten days.