Distinguishing community benefits: tax exemption versus organizational legitimacy.
Subject: Tax exemption (Reports)
Hospitals (Management)
Hospitals (Laws, regulations and rules)
Hospitals (Taxation)
Hospitals (United States)
Authors: Byrd, James D.
Landry, Amy
Pub Date: 01/01/2012
Publication: Name: Journal of Healthcare Management Publisher: American College of Healthcare Executives Audience: Trade Format: Magazine/Journal Subject: Business; Health care industry Copyright: COPYRIGHT 2012 American College of Healthcare Executives ISSN: 1096-9012
Issue: Date: Jan-Feb, 2012 Source Volume: 57 Source Issue: 1
Topic: Event Code: 920 Taxes; 200 Management dynamics; 930 Government regulation; 940 Government regulation (cont); 980 Legal issues & crime Advertising Code: 94 Legal/Government Regulation Computer Subject: Company business management; Government regulation
Product: Product Code: 8060000 Hospitals NAICS Code: 622 Hospitals SIC Code: 8062 General medical & surgical hospitals; 8063 Psychiatric hospitals; 8069 Specialty hospitals exc. psychiatric
Organization: Government Agency: United States. Internal Revenue Service
Geographic: Geographic Scope: United States Geographic Code: 1USA United States
Accession Number: 279261881

US policymakers continue to call into question the tax-exempt status of hospitals. As nonprofit tax-exempt entities, hospitals are required by the Internal Revenue Service (IRS) to report the type and cost of community benefits they provide. Institutional theory indicates that organizations derive organizational legitimacy from conforming to the expectations of their environment. Expectations from the state and federal regulators (the IRS, state and local taxing authorities in particular) and the community require hospitals to provide community benefits to achieve legitimacy. This article examines community benefit through an institutional theory framework, which includes regulative (laws and regulation), normative (certification and accreditation), and cultural-cognitive (relationship with the community including the provision of community benefits) pillars. Considering a review of the results of a 2006 IRS study of tax-exempt hospitals, the authors propose a model of hospital community benefit behaviors that distinguishes community benefits between cost-quantifiable activities appropriate for justifying tax exemption and unquantifiable activities that only contribute to hospitals' legitimacy.


The tax-exempt status of most US hospitals has increasingly been called into question by policymakers (Schneider 2009; Carreyrou 2008; GAO 2008; Schlesinger and Gray 2005). The Internal Revenue Service (IRS) may exempt hospitals and other organizations from income tax if they are operated exclusively for charitable, religious, educational, and other specific purposes; have no private individual ownership; do not benefit private shareholders or individuals; and do not participate in political lobbying (IRC 501(c)3). Critics of hospital tax exemption argue that many facilities do not supply sufficient community benefits to justify the financial benefit they receive from tax-exempt status (Meisel and Pines 2009). The IRS began collecting data with the 2008 annual filings required of tax-exempt entities (Form 990/Schedule H) in an attempt to quantify the amount of community benefit that is provided by tax-exempt hospitals in the United States (Lerner 2009).

One expectation from hospitals' customers and communities as well as federal and state regulators (the IRS and state and local taxing authorities in particular) is that hospitals provide community benefits. Accordingly, the community benefits hospitals provide contribute to their organizational legitimacy (Proenca, Rosko, and Zinn 2000). Community benefits include the quantifiable and nonquantifiable assistance an organization provides to its surrounding environment. In addition to the quantifiable benefits of offering indigent care and other free healthcare services, hospitals provide a wide variety of nonquantifiable benefits such as public health services, health education, community support, and community leadership.

Recent IRS reporting requirements are forcing hospital executives to gain a better understanding of the actual community benefit activities their facilities provide. While many of these benefits are perceived to be unquantifiable, cataloguing these activities may prove to be a wise exercise in light of increasing scrutiny surrounding hospital tax exemption. Additionally, a full understanding of the level of community benefit offered by a tax-exempt hospital can serve as a useful marketing tool and potential bargaining chip when negotiating with local policymakers. This article examines community benefit through the framework of institutional theory and proposes a model of community benefit behaviors for tax-exempt hospitals that distinguishes between activities that are appropriate for supporting tax exemption and those that contribute only to a hospital's legitimacy in the community. The relevance of these behaviors in supporting the IRS's beneficial tax treatment is discussed. Finally, an alternative characterization of community benefits related to organizational legitimacy is offered in an effort to clarify this issue.


Proponents of hospital tax exemption assert that the healthcare services hospitals provide satisfy the IRS community benefit requirement regardless of the amount of uncompensated care provided. Providing certain services lends hospitals organizational legitimacy relative to their peers and enables them to meet the community benefit standard for tax exemption (GAO 2008). Tax-exempt status is sometimes viewed by researchers as a surrogate for organizational legitimacy; however, other research challenges that presumption (Schlesinger, Mitchell, and Gray 2004). In fact, some researchers have demonstrated that both tax-exempt and for-profit hospitals have economic motivations to provide uncompensated care to meet community expectations (Davidoff et al. 2000).


Hospitals in the United States operate under various organizational forms that include tax-exempt entities operated for purposes other than generating profits for owners and taxable entities owned by private shareholders. A number of studies (Schneider 2009; Schlesinger, Mitchell, and Gray 2009; Horwitz 2005, Needleman 1999; Young, Desai, and Lukas 1997; Norton and Staiger 1994) have concluded that organizational form has little impact on a hospital's financial stability or the amount of uncompensated care or quality of service it provides. However, study conclusions are inconsistent (Rosenau 2003).

Researchers have asserted that the public might perceive hospitals with tax-exempt status as more trustworthy (having fairer pricing and higher quality healthcare) than their for-profit counterparts due to the absence of a profit motive, but this perception has not been validated empirically. The literature on hospital ownership conversions from tax-exempt to taxable status indicates that there is little or no discernible impact on hospitals' financial performance or quality of care before and after converting from one ownership structure to another (Needleman 1999; Young, Desai, and Lukas 1997). Consistent financial performance before and after an ownership conversion may indicate that the community's view of the hospital as a trustworthy entity is not altered by such a change.

Tax Exemption

Hospitals may be granted tax exemption as a result of their organizational form and their provision of charity care and other community benefits. They may be exempt from state and federal income taxes; state franchise and sales taxes; and local income, sales, and property taxes. State and local jurisdictions generally grant tax exemption only after the hospital obtains exempt status for federal income tax purposes from the IRS. Exemption is not automatic in the other jurisdictions. Once a hospital is granted exemption by the IRS, the hospital must then apply for exemption from the other authorities (Montoya and Meyer 1998).

The organizers or governing board of a hospital have the option to choose its tax status by their choice of hospital ownership and governance structure. While readily identifiable environmental and social factors may influence the organizational structure, studies have been unable to demonstrate that hospital corporate form is driven by the social environment (Young and Desai 1999). With little difference in the regulatory and social requirements applied to taxable for-profit hospitals and tax-exempt nonprofit hospitals, financial considerations rather than environmental factors appear to be driving the for-profit versus tax-exempt decisions.

The tax preference can be viewed as providing indirect financial assistance to hospitals for providing services for which they do not otherwise receive compensation. This indirect reimbursement provides financial assistance that may help a hospital keep its doors open even when the community it serves cannot afford to pay all of the costs plus the additional cost of taxable financing (higher interest rates on taxable bonds and dividends to shareholders). However, one study indicated that nearly 20 percent of tax-exempt hospitals in California did not provide community benefits in excess of the tax subsidies that they received (Morrisey, Wedig, and Hassan 1996).

Community Benefit

Community benefits have not been defined consistently. Some researchers have defined hospital community benefits as those services that are akin to public goods under economic theory (Nicholson et al. 2000). Lists of community benefits usually include uncompensated care, cost of medical research, and health education provided to the community. Sometimes Medicare, Medicaid, and third-party payer negotiated discounts are added to the list. For example, Missouri and Utah allow the Medicare and Medicaid discounts to be counted toward satisfying their community benefit requirement but Massachusetts does not (Nicholson et al. 2000). The Office of the Attorney General of the Commonwealth of Massachusetts provided a list of projects deemed community benefits but stated that the list was not all-inclusive (Coakley 2007).

The latest definition for federal income tax purposes resides in 1969 Revenue Ruling 69-545. With this ruling, the IRS indicated that organizations desiring to qualify for exemption from federal income tax must meet a community benefit standard. However, the IRS definition of community benefit is vague. Whether tax-exempt hospitals are deserving of their beneficial tax treatment has been a topic of considerable scrutiny and discussion for many years (Meisel and Pines 2009; Schneider 2009). In fact, the US Government Accountability Office (GAO) examined community benefits provided by taxexempt hospitals in 2005 and 2008 to help the IRS better understand them (GAO 2008).

In 2006, the IRS began a study to gain insight into the way tax-exempt hospitals apply the community benefit standard. The study results indicate a wide variation in the interpretation of the standard, with some hospitals defining it narrowly as the provision of free care while others take a broader approach that emphasizes the hospital's total role in the community (Lerner 2009). The study results suggest that a small portion of hospitals provide a disproportionately large amount of the community benefit expenditures (Lerner 2009). For example, 93 percent of the total medical research expenditures and 58 percent of the medical education and training expenditures were made by only 3 percent of hospitals surveyed. Uncompensated care accounted for only 56 percent of aggregate community benefit expenditures (Lerner 2009).

The IRS study reveals great inconsistency in how hospitals define community benefit. Respondents were allowed to use their own criteria in answering the questions. Some applied a restrictive definition including only uncompensated care while others applied a broad definition, in some cases trying to justify their exemption by providing normal hospital services and deemphasizing free care. Beginning with calendar year 2008 Form 990s, hospitals are required to provide additional information on a new Schedule H. The IRS will use the information collected on Schedule H to evaluate tax-exempt hospitals' compliance with the community benefit rule and determine if rule changes are needed.


Economic motivations drive management actions that determine how a business confronts and interacts with its environment. Institutional theory explains the impact on firm behavior that results from the social pressures and constraints placed on an organization by its environment (Scott 2005; Oliver 1997). An organization's environment includes not only its resources and competitors, but also the expectations and constraints placed on the organization by its function within society. A manager must understand her organization's role in a societal context in addition to an economic context (Drucker 1954; Barnard 1938). Further, organizations must obtain social justification by meeting societal expectations, complying with laws and regulations, and conforming to norms of moral behavior (Scott 1987). Organizational legitimacy is critical to an organization's viability, and this legitimacy is obtained by firms that justify their roles and positions within society (Scott 1987).

Scott developed a conceptual schema, the three pillars of institutions, that divides the basic elements that influence the organizational structure of a firm. These three classifications, (1) regulative, (2) normative, and (3) cultural-cognitive, "attempt to capture both the commonality and the diversity of theorizing about institutions" (Scott 2005).

Hospitals operate in a complex environment subject to rules and regulations from a multitude of sources. Therefore, a hospital's organizational legitimacy is heavily influenced by its regulatory environment (the regulatory pillar). The federal government is a major player through the funding and oversight from CMS, the SSA, and the IRS. These government agencies not only impact revenue (and therefore the financial ability of the hospital to exist), they also collect payroll taxes from hospitals and their employees.

Normative elements such as state licensing boards, The Joint Commission, and other quality review and accrediting bodies also play an institutional role influencing hospital structure and behavior. Hospitals must be responsive to private constituents in their communities. Third-party insurers, employers providing health insurance, people in the community served by the hospital, and hospital employees and their families are all normative institutional constraints on the behavior of a hospital.

Hospitals are intimately integrated into community social structures where they reside, perhaps more so than other types of businesses by virtue of having the potential to interact with every person in the community in which they operate. Accordingly, their structures and operations are exceptionally influenced by the elements from the cultural-cognitive pillar. Hospitals serve a social need by providing healthcare services to their community. Hospitals in areas with greater community accountability have been found to provide relatively greater charity care and services to disadvantaged groups (Lee, Chen, and Weiner 2004).

Categorization of Hospital Community Benefits

In 2006, the IRS surveyed 485 taxexempt nongovernmental hospitals to understand the type of community benefits being provided. Respondents listed a broad variety of community benefits that they used to justify tax exemption. Some hospitals included the provision of basic medical services typical to acute care hospitals (without considering uncompensated care). Other hospitals indicated the provision of extensive free care and unprofitable services, medical research and education, health promotion and patient education, and community outreach activities represented community benefit activities. Exhibit 1 summarizes the percentage of responding hospitals providing each type of community benefit included in the survey.

We developed a table of community benefits that segregates hospital services into four primary categories. The first two categories include cost-quantifiable community benefits reported to the IRS that we divided into two categories: (1) healthcare services and (2) other health-related activities. The costs of these benefits could be used to justify tax exemption. We then added two categories to capture other community benefits that contribute to the legitimacy of hospitals but could not justify tax exemption because they cannot be quantified: (3) community services; and (4) non-health service benefits provided to the community by a hospital. We included these categories to create a more inclusive list that takes into account legitimizing community benefits provided by a hospital. The detailed categorized list of services is presented in Exhibit 2.

The column headings illustrate the various financial categorization of each of the services. Cost-quantifiable services (categories 1 and 2) were reported to the IRS. Category 1 includes normal hospital services referred to collectively as uncompensated care. Ninety-five percent of hospitals responding to the IRS survey reported providing uncompensated care. The most commonly reported benefit, charity care, is free care that is usually provided on a needs basis with no intent to bill or collect for services. Bad debt, reported by approximately 44 percent of the respondents, is care billed to the patient that has not successfully been collected. Medicare and Medicaid discounts represent differences between the standard rates according to the hospital's fee schedule and the reimbursement rates from Medicare and Medicaid. Approximately 20 percent of the respondents included Medicare and Medicaid discounts as community benefits in their responses to the IRS.

Category 2 includes other healthcare-related activities, such as medical education and medical research. These are services outside of the normal spectrum of hospital services to patients and therefore not billed but are healthcare-related activities that provide benefits to the community. Almost 80 percent of the respondents reported health promotion, patient education, and community outreach activities. Twenty-one percent provided medical research. While not billed to individuals for personal medical services, the costs of these activities can be determined and could be used to justify tax exemption under some kind of financial incentive approach.

Category 3 activities include more intangible health-related community support activities. In general, these activities do not require large out-of-pocket costs but are part of the hospital's benefit to the community as a healthcare and community leader. Coordination with local health departments for disaster response planning is an example of a specific initiative that would be included in this category. Other activities, including coordinating care with nursing homes and mental health centers and serving as the community's safety-net hospital, provide significant value to the community, though the cost to the hospital is difficult or impossible to determine.

Category 4 includes the types of activities that are conducted by all viable businesses in the community. A business provides economic benefits as an employer, resource consumer, and resource generator. A hospital construction project is one way a hospital benefits the community through economic stimulation. Both Category 3 and Category 4 activities relate to legitimizing the hospital as a valuable institution to their community. These activities add value, but the cost to the hospital is difficult if not impossible to assess, so they may not be appropriate for justifying tax exemption.

Institutional theory defines legitimacy as it relates to the community benefits that the hospital provides. This terminology implies that benefits are measured by their value to the community instead of the cost to the hospital. Costs and values are usually quantified differently, so cost of the benefits and value of the benefits should not be used interchangeably.


The similarities in service quality, indigent care services, and financial performance between tax-exempt and for-profit hospitals seem to indicate that tax exemption is irrelevant to the legitimacy of a hospital. Instead, the hospital's social role in the community is more important. Institutional theory indicates that organizations adopt structures and design services in response to the social pressures and constraints placed on them by their institutional environments. The wide variety of community benefit services provided by both tax-exempt and for-profit hospitals indicates that both types are competing for the same resources and, therefore, are attempting to conform to similar institutional pressures. Tax exemption is simply an organizational alternative available to the hospitals willing to comply with the IRS requirements for tax-exempt entities.

Many hospitals operate on such thin margins that relief from tax burden is critical to their financial survival. While the IRS tax exemption is the starting point for exemption in state and local jurisdictions, these other authorities often add their own minimum community benefit requirements and definitions for a hospital to maintain tax exemption for that jurisdiction. The IRS study and further data collection likely will result in more precise tax-exemption rules and requirements for federal tax exemption in the future. Tax-exempt hospitals can be partitioned into tiers based on their levels of community benefit provision following a categorization of types as presented in Exhibit 2, or based on the cost of certain IRS prescribed benefits that a hospital provides. Certain benefits from categories 1 and 2 could be used to support exemption. For example, the cost of uncompensated care would be a qualifying benefit because these benefits contribute directly to providing care to the needy, while third-party payer discounts would not because they relate to insurance-type payments at a rate intended to provide full payment for services rendered. Perhaps a sliding scale of taxation should be assigned to these facilities based on the community benefits they offer. However, without a firm definition of which services and activities qualify as provision of community benefit, no real determination can be made regarding the value society derives from tax-exempt hospitals. Policymakers should take this into consideration prior to making sweeping reforms relevant to hospital tax exemption.

From a theoretical perspective, tax exemption appears to be relevant to finance but irrelevant to legitimacy or structure. Therefore, further research on hospital legitimacy should ignore the distinction in tax structure and treat tax exemption as a financing consideration rather than a social characteristic. Isolating this element as strictly financial shifts the treatment of tax exemption allowed by a regulatory agency (e.g., the IRS), and its requirement for providing an equivalent monetary amount of free care, out of the cultural-cognitive pillar to the regulatory pillar. Only those elements of community benefit related to building intangible community relationships should be considered within the cultural-cognitive pillar. Moving hospital tax-exempt status into the regulatory pillar provides a depiction of financial effects on legitimacy that is better aligned with society's view of tax exemption as compensation for providing free care.

From a managerial perspective, recent IRS reporting requirements are forcing hospital executives to gain a better understanding of the actual community benefit activities their facilities provide. While many of these benefit offerings are perceived to be unquantifiable, cataloguing these activities may prove to be a wise exercise in light of increasing scrutiny surrounding hospital tax exemption. Additionally, a full understanding of the level of community benefit that a tax-exempt hospital provides can serve as a useful marketing tool and a potential bargaining chip when negotiating with local policymakers.


Despite current conversations swirling around hospital tax exemption, no clear definition of community benefit has been offered by the IRS. However, the agency is undertaking a clear mission of attempting to identify the amount and kinds of such activities tax-exempt hospitals are performing. The amount of charity care provided by tax-exempt hospitals is not materially different from that provided by for-profit facilities. Therefore, it is reasonable to assume that tax-exempt hospitals will continue to face scrutiny and be required to defend their tax-exempt statuses.


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Natalie Dean-Wood, FACHE, director, Community Health Improvement, Texas Health Resources, Arlington, Texas

The function of community benefit continues to evolve. Gray areas still exist, but various organizations with faith-based, community-focused missions have been successful in creating standards and guidelines to aid in achieving legitimacy and supporting tax exemption. Reflecting on my experience in the field of community benefit and community health, I believe the conceptual framework of the three pillars of institutions (developed by Scott and cited by Byrd) encompasses the characteristics of current practice. The framework contains the foundational components currently in use and supports IRS's Schedule H. Categorizing elements to capture community benefit activities has come a long way, but work is still needed to create uniformity across the field that supports tax exemption and embraces health status improvement. This work should focus on common definitions for the cost quantifiable and non-quantifiable elements for organizational legitimacy and tax exemption.

Current practice and the concept Byrd presents place financial philosophy as the root for legitimacy and measurement. In my opinion, an additional area of opportunity will affect organizational goals and community health status efforts. The opportunity lies in strategy development for community benefit that includes community health needs assessment (CHNA) and a service line rigor similar to finance and patient care. Some key elements to be included in community benefit strategy development are Board of Trustees and leadership education, the establishment of infrastructure to manage a community benefit program, a performance measure scorecard, and a recognition mechanism linked to performance.

As the conversation on hospital tax exemption continues and the debate between for-profits and nonprofits escalates, the field should take steps back to move forward. In stepping back, common definitions and methodology regarding the quantifiable elements (charity care, bad debt, and tax value) should be created so that a common platform is in place as a starting point. As CHNAs become a key component of meeting community benefit expectations, the current standards and guidelines will need to be evaluated, enhanced, and updated continuously to meet the changing societal environment.

The field must successfully generate uniformity by establishing common definitions and measuring the impact, positive effect on health status, and return on investment of community benefit activities. Once these steps are taken, distinguishing community benefit for tax exemption and organizational legitimacy will become less obscure and more embraced within standard operations.


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United States Department of the Treasury Internal Revenue Service. 2010. "New Requirements for 501 (C)(3) Hospitals Under the Affordable Care Act." www.irs.gov/charities/charitable/ article/0,,id=236275,00.html.

James D. Byrd, MBA, MAC, doctoral student, health administration, University of Alabama at Birmingham, and Amy Landry, PhD, assistant professor, health administration, University of Alabama at Birmingham
Types of Hospital Community Benefits from IRS 2006 Nonprofit
Hospital Study

The percentages represent the percent of hospitals responding to
the IRS study that indicated they included that type of benefit
in their definition of "community benefits" (n= 485)

UNCOMPENSATED CARE                                  95%
  Charity care                                    (Note (1))
  Bad debt write-offs                               44%
  Medicare discounts                                20%
  Medicaid discounts                                20%
  Other discounts (private insurance, self-pay)      51
  Medical education                                 77%
  Medical research                                   21
  Health promotion and patient education
    Lectures and seminars                           79%
    Newsletters and publications                    76%
    Improving access to healthcare                  56%
  Other health promotion                            31%
  Community outreach
    Community health assessments and screenings     77%
    Immunization programs                           41%
    Studies re: unmet healthcare needs              28%

Note (1): Due to the inconsistencies in the definitions of charity
care and bad debts used by the respondents the IRS was unable
to identify the percentage of hospitals that provided charity
care separately from other types of uncompensated care.

Source: Results from 2006 IRS Nonprofit Hospital Study of 485
tax-exempt nongovernmental hospitals (Lerner 2009).

Proposed Model of Hospital Community Benefit Behaviors

                                                 Billed Not   pocket
                                                 Collected     Costs

  Uncompensated care
    Charity care
    Bad debt write-offs                              X           X
    Medicare discounts
    Medicaid discounts
    Other means tested programs
    Unprofitable services                            X           X
  Medical education                                              X
  Medical research                                               X
  Health promotion and patient education
    Lectures and seminars                                        X
    Newsletters and publications                                 X
  Other health promotion                                         X
  Community outreach
    Community health assessments and                             X
    Immunization programs                                        X
    Studies re: unmet healthcare needs                           X
  Coordination with and support of
    other community agencies                                     X
    local health departments                                     X
  Serve as the safety-net health provider
  Improving access to healthcare
  Community-building activities such as
    economic development

                                                 Agreed-to   Intangible
                                                 Discounts    Benefits

  Uncompensated care
    Charity care                                     X
    Bad debt write-offs
    Medicare discounts                               X
    Medicaid discounts                               X
    Other means tested programs                      X
    Unprofitable services
  Medical education
  Medical research
  Health promotion and patient education
    Lectures and seminars
    Newsletters and publications
  Other health promotion
  Community outreach
    Community health assessments and
    Immunization programs
    Studies re: unmet healthcare needs
  Coordination with and support of
    other community agencies                                     X
    local health departments                                     X
  Serve as the safety-net health provider                        X
  Improving access to healthcare
  Community-building activities such as                          X
    economic development
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