18

accounting for premium payments received. In general, property
and casualty insurance companies are entitled to deduct increases
in reserves which affect premium income. Organizations that are
not insurance companies, by contrast, are not entitled to deduct
increases in reserves but rather, generally account for
deductions in accordance with the all events test and the rules
for determining when economic performance has occurred. The
allowance of a deduction for Federal income tax purposes with
respect to reserves of property and casualty insurance companies
generally reflects the fact that payments (premium income) are
generally received in a taxable year earlier than the year in
which the loss is incurred or paid.

If an HMO receives payments that resemble the premiums
received by insurance companies in these respects, it appears
appropriate to tax them under the regime applicable to property
and casualty insurance companies. On the other-hand, if an HMO
receives prepayments for medical services it directly provides,
reserve deductions are arguably inappropriate, and the
organization should not be treated as a property and casualty
insurance company. Because the manner of organization and
operation of HMOs varies and may change rapidly with business
trends, consideration should be given to whether one rule is
appropriate for all taxable HMOs. On the other hand, it may not
be administratively feasible to distinguish among types of
payments received by HMOs.

With respect to treatment of reserves, some taxable HMOs
take the position that they are subject to taxation as property
and casualty insurance companies. Others, however, may take the
position that, although they may be subject to State regulation
and financial reporting requirements as insurance companies, they
are not taxable as property and casualty insurers. Such
organizations nevertheless may claim tax deductions for reserves
on the theory that the risk of loss has shifted to them. These
organizations may argue that, because they are not taxable as
property and casualty insurers, they are not subject to the
limitations on reserve deductions imposed on property and
casualty insurance companies. Thus, as a practical matter, the
regime prescribed under the bill may represent a significant
change only for taxable HMOs that take the position that they are
not taxable as property and casualty companies.

An additional issue relates to the operation of the property
and casualty company tax regime. Treating HMOs as property and
casualty insurers could be criticized on the ground that the
present-law regime for taxing such entities is flawed in certain
respects. For example, present law provides for a pre-tax method
of discounting loss reserves of property and casualty insurance
companies which only partially takes account of the time value of
money. It is arguable whether taxpayers not explicitly subject
to this regime should be made explicitly subject to it without



12

care which is not provided pursuant to a pre-existing arrangement
between the HMO and a health care provider (other than emergency
care provided to a member of such organization at a location
outside such member's area of residence). Under this rule,
commercial-type insurance would include plans under which an HMO
member can select any health-care provider, the HMO pays a
portion of the costs of such provider, and the member is
obligated to pay the remaining portion. Such arrangements are
commonly referred to as providing "point of service" or "fee-for-
service" benefits (i.e., the member decides which medical
provider to use at the point at which service is required).
However, the provision of emergency care, even if on a point of
service basis, to HMO members outside their area of residence
would not constitute commercial-type insurance.

The bill would specifically identify four types of health
insurance provided by an HMO that would not be treated as
commercial-type insurance and, thus, would not jeopardize the
organization’s tax-exempt status. Such non-commercial-type
health insurance coverages generally address emergency situations
and situations in which a health care provider has a pre-existing
relationship with an HMO whereby the HMO exerts control over
either the fee charged by the service provider or the member’s
use of such provider's services.

First, insurance relating to care provided by an HMO to its
members at its own facilities through health care professionals
who do not provide substantial health care services other than on
behalf of such HMO would not constitute commercial-type
insurance. Such arrangements are characteristic of "staff model"
or "group model" HMOs which hire health care providers (as
employees or independent contractors) to provide services to
members on an exclusive basis.

Second, insurance relating to primary care provided by a
health care professional to a member of an HMO on a basis under
which the amount paid to such professional does not vary with the
amount of care provided to such member would not constitute
commercial-type insurance. This rule addresses situations in
which an HMO pays health care providers on a "fixed" or
"capitated" basis for primary care services rendered to members.
Although such fees may be based on the number of members served
by such provider, they may not be based on the extent of services
provided to a member.

Third, insurance which relates to the provision of services
other than primary care, if provided pursuant to a pre-existing
arrangement with an HMO, would not be commercial-type insurance.
This exception is intended to address situations in which an HMO
member is referred by his or her primary care provider to a
specialist who is a member of an HMO’s so-called "provider
network," even if the amount paid to the specialist varies with



and local taxes.

Hospitals as tax-exempt entities

Although Code section 501(c) (3) does not specifically
mention furnishing medical care and operating a not-for-profit
hospital, such activities have long been considered to further
charitable purposes.* However, the mere provision of not-for-
profit medical care is not, by itself, sufficient to allow an
organization to qualify for exemption under section 501(c) (3).
Rather, an organization must demonstrate that its activities are
targeted to a charitable class. The precise nature of that
charitable class has been and continues to be a source of
controversy.

In 1956, the Internal Revenue Service (IRS) issued Revenue
Ruling 56-185, 1956-1 C.B. 202, setting forth the conditions that
a not-for-profit hospital must satisfy to qualify for recognition
as a tax-exempt charitable organization under section 501(c) (3).
The IRS ruled that a hospital would be exempt if it met the
following four conditions: (1) it must be organized as a
not-for-profit organization for the purpose of operating a
hospital for the care of the sick; (2) it must be operated, to
the extent of its financial ability, for those not able to pay
for the services rendered and not exclusively for those able and
expected to pay; (3) it must not restrict use of its facilities
to a particular group of physicians; and (4) its earnings must
not inure, directly or indirectly, to the benefit of any private
shareholder or individual (this last requirement merely restated
a restriction generally applicable to all organizations under
section 501(c) (3)).

With respect to the "financial ability" requirement, the IRS
noted that:

The fact that its charity record is relatively low
is not conclusive that a hospital is not operated for
charitable purposes to the full extent of its financial
ability. It may furnish services at reduced rates
which are below cost, and thereby render charity in
that manner. It may also set aside earnings which it
uses for improvements and additions to hospital
facilities. It must not, however, refuse to accept
patients in need of hospital care who cannot pay for
such services. Furthermore, if it operates with the

5 Although not-for-profit hospitals generally are
recognized as tax-exempt by virtue of being "charitable"
organizations, some may also qualify for exemption as "educational
organizations" because they are organized and operated primarily
for medical education purposes.



19

addressing its failure to take account fully of the time value of
money. Further, some might assert that the regime of complete or
partial tax exemption for small property and casualty companies
May not be appropriate for HMOs that fail to qualify for tax-
exempt status under 501(c) (3) or 501(c) (4). :

As a technical drafting matter, the statutory structure set
forth in the bill appears redundant in defining both criteria for
tax-exempt status and criteria for taxable status. Rather than
simply characterizing all organizations that are not tax-exempt
as taxable, the bill would set forth one standard for tax
exemption and another, different, standard for taxability.
Conceivably, some organizations could fail to meet either set of
criteria. In addition, the taxability standards themselves could
be criticized as vague. Because neither present law nor the bill
defines an HMO, the second standard ("operating as an HMO") is
difficult to apply at best.

The bill would also require that the three enumerated
activities constitute the primary and predominant business
activity of an organization. This standard is similar to a rule
set forth in Treasury regulations that describes an insurance
company as one whose primary and predominant business activity is
the issuing of insurance or annuity contracts or the reinsuring
of risks underwritten by insurance companies, and has been
variously interpreted in judicial decisions. While the bill does
state that administering accident and health insurance contracts
is treated as part of the activity of issuing accident and health
insurance contracts or reinsuring accident and health risks (for
an organization that has issuing such contracts or reinsuring
such risks as a material business activity), the bill would not
specify the nature and amount of other activities that a company
may conduct and still be treated as a property and casualty
insurance company. Because this standard does not provide a
bright-line test, without further clarification, it could be
criticized as an inadequate basis for determining the tax status
of an organization.

Finally, because the effective date of this provision would
be deferred until taxable years beginning after 1996, additional
rules may be needed to forestall opportunities for manipulation
of accounting items for organizations that become taxable under
the bill (or whose accounting method is changed) and, thus,
become subject to the provision. For example, the bill does not
contain a rule comparable to that provided in the Tax Reform Act
of 1986 (the "1986 Act") to limit reserve weakening by
organizations immediately prior to the point at which they become
taxable.



16
of the private sector.

The system of universal health care coverage envisioned
under the bill represents a significant quantitative, and perhaps
also qualitative, expansion of Federal participation in
financing health care. Accordingly, it may be appropriate to
reexamine the circumstances under which the provision of medical
care would constitute a charitable function in such a system.
Presumably, teaching institutions could continue to be eligible
for tax exemption as educational organizations. However, if all
Americans have access to health care, what other, if any,
activities distinguish a nonprofit from a for-profit health care
provider? For example, would nonprofit hospitals provide charity
care where gaps exist in the system of universal coverage?

These questions are particularly apt in light of the
significant financial benefits for which charitable organizations
are eligible. It is not clear, for example, that allowing such
organizations continued access to tax-exempt financing is
appropriate in a system in which the Federal Government provides
considerable direct subsidies (for example, the Federal payments
to alliances outlined in Title IX, Subtitle B of the bill). With
respect to regional and corporate health alliances, section 7902
of the bill would provide that regional and corporate health
alliances be treated as private businesses that are not eligible
for tax-exempt financing. This raises the further question of
why such alliances should be treated differently than other
medical service providers exempt under section 501(c) (3).

Finally, it is not clear whether the community needs
assessment and plan development requirements set forth in the
bill are intended to replace or supplement present-law standards
for exemption. In addition, the scope of organizations subject
to the requirements is unclear. The bill states that the
requirements apply to hospitals, HMOs and "other entities
providing health care services." A wide variety of organizations
exempt under section 501(c) (3) provide an equally wide range of
health care services. For example, a half-way house for
alcoholics, a blood bank, a childbirth education organization, a
clinic to aid drug victims, an organization that provides home
health care, homes for the elderly, and nursing homes all have
qualified for exemption under section 501(c) (3). Do the
community needs assessment and plan development requirements
apply to all of these organizations, as well as to hospitals and
HMOs?

Insurance activities of tax-exempt organizations

Similarly, it may be appropriate to reexamine the
characterization of certain forms of insurance provided by HMOs
as commercial- or non-commercial-type insurance. The bill
generally appears to codify positions developed by the IRS with



HMOs a le enti Ss

In fact, the majority of HMOs are not organized as tax-
exempt entities. At the beginning of 1990, there were 575 HMOs
nationwide, approximately two-thirds of which were organized and
operated as taxable, for-profit businesses. The primary issue
for such taxable HMOs concerns their ability to deduct additions
to reserves established out of premium payments to cover accrued
liabilities (so-called "incurred but not reported" or "IBNR"
claims). In general, accrual method taxpayers are not entitled
to deduct expenses until all events necessary to fix and
determine the taxpayer’s obligation have occurred (the "all
events" test). In addition, section 461(h) imposes an economic
performance requirement which, in general, postpones deductions
until payment.

Property and casualty insurance companies are entitled to
deduct IBNR reserves without regard to the "all events" test or
the economic performance requirement. Such reserve deductions
are, however, subject to certain limitations. For example,
reserve deductions by an insurance company must be discounted on
a pre-tax basis to take account partially of the time value of
money, and unearned premium reserve deductions must be reduced by
20 percent.“ Thus, the tax treatment of a taxable HMO depends
largely on the extent to which it qualifies as an insurance
company.

part theory if the taxpayer performs an essential service directly
to its affiliates, but not if it provides such services to
unrelated organizations. Alternatively, the taxpayer may provide
services on behalf of its exempt affiliates directly to the class
of charitable beneficiaries of such affiliates. The Tax Court
concluded GHP did not qualify for tax-exempt status under the

integral part theory. Geisinger Health Plan v. Commissioner, 100

T.C. No. 26, filed May 3, 1993.

3 See, T.J. Sullivan, "The Tax Status of Nonprofit HMOs
After Section 501(m)", Tax Notes, January 7, 1991.

“Present law also provides that property and casualty
insurance companies are eligible for exemption from Federal income
tax if their net written premiums or direct written premiums
(whichever is greater) do not exceed $350,000; and further provides
that a company with such premiums in excess of $350,000 but less
than $1.2 million may elect to be taxed only on taxable investment
income (and thus, generally to exclude underwriting income from
tax) (sec. 501(c) (15)).

1s Under Treas. Reg. sec. 1.801-3(a), to constitute an
“insurance company," a company must be one whose primary and
predominant business activity is the issuing of insurance or
annuity contracts or the reinsurance of risks underwritten by



5

also had a board of directors drawn from the community, an open
medical staff policy, treated persons paying their bills with the
aid of public programs (such as Medicare and Medicaid), and
applied any surplus receipts to improving facilities, equipment,
patient care, and medical training, education and research.

The community benefit standard was challenged in a class
action by various health and welfare organizations and several
private citizens on the grounds that it failed adequately to
identify a charitable class. In Eastern Kentucky Welfare Rights
Organization v. Simon, 370 F. Supp. 325, 338 (D.D.C. 1973), a
Federal District Court sustained the challenge, and concluded
that Congress intended to restrict the term charitable to its
narrow sense of relief of the poor. The United States Court of
Appeals reversed the District Court, however, and upheld the IRS’
broader interpretation of "charitable" reflected in Revenue
Ruling 69-545.° The Court of Appeals explained that the term
"charitable" is "capable of a definition far broader than merely
the relief of the poor." The Court also noted that the community
benefit standard did not supplant the "financial ability"
requirement of Revenue Ruling 56-185, but rather represented an
alternative method whereby a not-for-profit hospital could
qualify as a tax-exempt charitable organization.

p= intenance aniza HMOs ex t entities

The same community benefit standard for determining whether
a hospital is a tax-exempt charitable organization applies in
determining whether a health maintenance organization ("HMO")
qualifies for tax-exempt status under section 501(c)(3). In this
context, the IRS has developed a fairly comprehensive list of
characteristics that distinguish tax-exempt charitable HMOs from
other HMOs. Although an HMO seeking exemption as a social
welfare organization under section 501(c) (4) is not required to
possess all of the same characteristics as an HMO that qualifies
for exemption under section 501{c) (3), its activities must
generally satisfy a community benefit standard similar to, but
less exacting than, that imposed on charitable HMOs.’

In general, HMOs represent one form of managed health care
delivery organization. Although there is case law regarding the

the hospital promoted the health of a class of persons broad enough
to benefit the community.

§ Eastern Ky. Welfare Rights Org. v. Simon, 506 F.2d 1278

(D.C. Cir. 1974), vacated on other grounds, 426 U.S. 26 (1976).

7 See GCM 39829 (August 30, 1990) which reviews the IRS’
position regarding HMOs and considers the extent to which HMOs
customarily act as providers of health services or insurance.



4

expectation of full payment from all those to whom it
renders services, it does not dispense charity merely
because some of its patients fail to pay for the
services rendered.

Three years after publication of Revenue Ruling 56-185, the
Treasury Department significantly revised its regulations
interpreting section 501(c) (3). The amended regulations provided
that:

The term "charitable" is used in section 501(c) (3)
in its generally accepted legal sense and is,
therefore, not to be construed as limited by the
separate enumeration in section 501(c) (3) of other
tax-exempt purposes which may fall within the broad
outlines of "charity" as developed by judicial
decisions.‘

Relying upon the amended regulations, the IRS issued Revenue
Ruling 69-545, 1969-2 C.B. 117, which considered whether two
nonprofit hospitals qualified for Federal tax exemption. In
establishing the so-called "community benefit" standard, the IRS
noted that the promotion of health is "one of the purposes in the
general law of charity that is deemed beneficial to the community
as a whole even though the class of beneficiaries eligible to
receive a direct benefit from its activities does not include all
members of the community, such as indigent members of the
community, provided that the class is not so small that its
relief is not of benefit to the community." The IRS specifically
modified Revenue Ruling 56-185 to eliminate the requirement
relating to caring for patients without charge or at rates below
cost.

The "community benefit" standard, which remains the
principal standard applied by the IRS today, focuses on a number
of factors which indicate that the operation of a hospital
benefits the community rather than serving private interests. In
Revenue Ruling 69-545, the IRS determined that the standard was
satisfied by a hospital that operated an emergency room open to
all persons and provided hospital care in non-emergency
situations for everyone able to pay the cost thereof, either
themselves, or through third-party reimbursement.’ The hospital

4 Treas. Reg. sec. 1.501(c) (3) -1{(d) (2).

5 In Rev. Rul. 83-157, 1983-2 C.B. 94, the IRS clarified
that the operation of an emergency room was not a prerequisite for
hospital exemption, if a State health planning agency made an
independent determination that the operation of an emergency room
would be unnecessary and duplicative, and provided that other
factors set forth in Rev. Rul. 69-545 were present indicating that



17

respect to various payment arrangements established by HMOs under
a health care system very different from the one proposed in the
bill.

In addition, the provisions regarding characterizing
insurance arrangements as commercial or non-commercial appear
somewhat inconsistent with other provisions of the proposed
health plan. For example, the bill would characterize "point of
service" or "fee-for-service" plans offered by HMOs as
commercial-type insurance. However, section 1402(d) of the bill
would require certain health plans (e.g., those that offer .
enrollees the lower cost sharing schedule described in section
1132 of the bill) to offer fee-for-service coverage. If
participants elect such coverage to the extent that it
constitutes a substantial portion of such HMO’s activities, the
HMO could lose its tax-exempt status.

Defini of 1 roper alty i ance my

The bill would expand the definition of taxable property and
casualty insurance companies to include organizations that are
not tax-exempt, are not life insurance companies, and that meet
one of three tests. The first is insurance or reinsurance of
accident and health risks (a traditional activity of insurance
companies). The second is operation as an HMO, and the third
appears to encompass arrangements similar to those which an HMO
might enter into, whether or not. it purports to be an HMO (i.e.,
arrangements to receive fixed payments as consideration for
providing or arranging to provide health care services,
regardless of the amount of health care services provided) .

Thus, the bill would treat taxable HMOs and taxable organizations
that operate like HMOs as property and casualty insurance
companies.

However, it is not self-evident that all taxable HMOs should
be taxed as property and casualty insurance companies. The
underlying presumption appears to be that if an HMO is not tax-
exempt, its activities involve the provision of insurance
services as opposed to medical services. This presumption is
based on what traditionally has been a key distinction between
HMOs and hospitals; HMOs deliver prepaid benefits whereas
hospitals are paid on a fee-for-service basis.

Several issues are raised in determining whether a taxable
HMO (for example, an HMO that.is not tax-exempt because it is
organized on a for-profit basis) sufficiently resembles a
property and casualty insurance company to be taxed as one. One
is whether deductions for reserves are appropriate to the
operation of an organization that directly provides medical care.

A central issue in determining whether an HMO should be
taxed as a property and casualty insurer is the method of



7

exemption under section 501(c) (3) include: actual provision of
health care services and maintenance of facilities and staff;
provision of services to nonmembers on a fee-for-service basis;
care and reduced rates for the indigent; care for those covered
by Medicare, Medicaid or other similar assistance programs;
emergency room facilities available to the community without
regard to their ability to pay (and communication of this fact to
the community); a meaningful subsidized membership program; a
board of directors broadly representative of the community;
health research programs; health care providers who are paid ona
fixed-fee basis; and the application of any surplus to improving
facilities, equipment, patient care, or to any of the above
programs. The IRS noted, however, that these factors are not
all-inclusive, nor is the absence of any one determinative of the
lack of a charitable operation.!!

More recently, in Geisinger Health Plan v. Commissioner, 985
F.2d 1210 (3rd Cir. 1993), the Court of Appeals for the Third
Circuit applied the factors set forth in Sound Health Association
and held that Geisinger Health Plan (GHP), a network model HMO,
did not qualify for tax-exempt status under section 501(c) (3)
because its activities did not primarily benefit the community.
GHP did not provide any health services directly, but contracted
to provide health services with other health care providers
(which typically were other entities related to GHP). In
addition, the Court noted that operating a subsidized dues
program for 35 otherwise medically underserved individuals did
not benefit the community sufficiently to overcome GHP’s primary
purpose of providing benefits only to its members.”

n See, e.g., GCM 38735 (May 29, 1981) (concluding that
staff model HMOs that have truly open membership, directly provide
services to members and nonmembers, maintain an open emergency
room, and treat patients regardless of ability to pay may be exempt
under section 501(c) (3)); and GCM 39057 (Nov. 9, 1983) (ruling that
an IPA model HMO which arranged for health caré services through an
affiliated, physician-owned IPA that controlled the HMO does not
qualify for exemption under section 501(c)(3)}. In GCM 39057, the
IRS explicitly expressed no opinion as to whether the HMO in
question could qualify for exemption under section 501(c) (4).

ad The Court of Appeals remanded the case to the Tax Court
for a determination of whether GHP could qualify for 501(c) (3)
Status as an "integral part" of an exempt organization. The
integral part theory set forth in Treas. Reg. sec. 1.502-1(b)
provides generally that an organization is entitled to exemption as
an integral part of a tax-exempt affiliate if its activities are
carried out under the supervision or control of an exempt
organization and could be carried out by the exempt organization
without constituting an unrelated trade or business. The Tax Court
noted that a taxpayer may qualify for exemption under the integral



DESCRIPTION AND ANALYSIS OF PROVISIONS
IN THE HEALTH SECURITY ACT (H.R. 3600)
RELATING TO THE TAX TREATMENT
OF ORGANIZATIONS PROVIDING HEALTH CARE

SERVICES AND RELATED ORGANIZATIONS

Scheduled for a Hearing
Before the
SUBCOMMITTEE ON SELECT REVENUE
MEASURES
of the
HOUSE COMMITTEE ON WAYS AND ‘MEANS

on December 14, 1993

Prepared by the Staff
of the
JOINT COMMITTEE ON TAXATION
December 13, 1993

JCX-15-93



10

Section 833 provides three special rules for organizations
within its scope. First, eligible organizations are treated as
stock insurance companies. Second, section 833 exempts eligible
organizations from the rule (referred to above) that is generally
applicable to property and casualty insurance companies,
requiring a 20-percent reduction in the amount a company can
deduct for any increase in unearned premium reserves.'* Thus,
eligible organizations are not required to reduce the deduction
for increases in unearned premium reserves. Third, eligible
organizations are entitled to claim a special deduction with
respect to their health business in an amount equal to 25 percent
of claims and expenses incurred during the taxable year, less
adjusted surplus at the beginning of the year.

The transition rules in section 833 provide that no
adjustment was to be made on account of a change in such an
organization's method of accounting for its first taxable year
beginning after that date. The transition rules also provide
that, for purposes of determining gain or loss, the adjusted
basis of any asset of such an organization held on the first day
of the taxable year beginning after December 31, 1986, was
treated as equal to its fair market value as of such day. Rules
were also provided to limit adjustments to surplus that could
affect the amount of the special deduction, and to treat reserve
weakening after August 16, 1986, as occurring in the
organization’s first year as a taxable organization.”

D xr on of Provisions
Tax-ex t status of hospi s, HMOs, certai: ent
organiz. ons and regional iances

The bill would establish certain new requirements applicable
to nonprofit health care providers (hospitals and HMOs) seeking

8 The 20-percent reduction requirement was added by the
1986 Act, effective for taxable years beginning after December 31,
1986. The 1986 Act also required the inclusion in income ratably,
over the ensuing six-year period, of 20 percent of the unearned
premium reserve outstanding at the end of the most recent taxable
year beginning before January 1, 1987. The inclusion was required
at the rate of 3-1/3 percent of such outstanding unearned premium
reserve in each of the first six taxable years beginning after
December 31, 1986.

9 Because increases in reserves are generally deductible by
a taxable insurer, a reduction in reserves (so-called "reserve
weakening") immediately prior to the time a tax-exempt organization
becomes a taxable insurer could allow the organization to claima
bigger deduction than it would otherwise be entitled to after it
becomes taxable.



9

Insurance activities of tax-exempt organizations

Under section 501(m), an organization described in section
501(c) (3) or 501(c) (4) of the Code is exempt from tax only if no
substantial part of its activities consists of providing
commercial-type insurance. Commercial-type insurance generally
includes any insurance of a type provided by commercial insurance
companies, subject to certain exceptions. For example,
commercial-type insurance does not include insurance provided at
substantially below cost to a class of charitable recipients. In
addition, section 501(m) (3) (B) provides that commercial-type
insurance does not include incidental health insurance provided
by an HMO, of a kind customarily provided by an HMO.’

Special rules applicable to certain taxable insurance companies

When section 501(m) was enacted in 1986, special rules were
added to benefit certain organizations that no longer qualified
as tax-exempt organizations and became subject to tax as
insurance companies under subchapter L. Section 833, enacted
concurrently with section 501(m), provides special relief for
Blue Cross and Blue Shield organizations existing on August 16,
1986, which were exempt from tax for their last taxable year
beginning before January 1, 1987, and which have experienced no
material change in their structure or operations since August 16,
1986. In addition, section 833 provides special relief for
certain other organizations, substantially all of the activities
of which involve the provision of health insurance, that meet
certain community-service-related requirements.”

insurance companies.

6 See GCM 39829 (August 30, 1990) for a discussion of the
legislative history of the enactment of section 501(m) and the HMO
exception in section 501(m) (3) (B).

uv These community service requirements are: (1
substantially all the activities of the organization involve
providing health insurance; (2) at least 10 percent of the health
insurance is provided to individuals and small groups (not taking
into account medicare supplemental coverage); (3) the organization
provides continuous full-year open enrollment (including
conversions) for individuals and small groups; (4) the policies
covering individuals provide full coverage of pre-existing
conditions of high-risk individuals without a price differential
(with a reasonable waiting period), and coverage is without regard
to age, income, or employment status of individuals under age 65;
(5) at least 35 percent of its premiums are community rated; and
(6) no part of its net earnings inures to the benefit of any
private shareholder or individual.



6

tax treatment of HMOs, the Code does not define an HMO.* In
general, HMOs have structured their delivery of medical care in
accordance with four basic models: (1) a "staff model" HMO
employs its own doctors and staff and serves its members at its
own central location; (2) a "group model" HMO contracts with an
existing group of physicians to perform services at the HMO’s
central location; (3) an "IPA model" HMO contracts with
physicians, often through an individual practice association
("IPA"), to provide care to HMO members at the physicians’ own
offices; and (4) a "network model" HMO provides care to its
members through a network of independent medical groups.’

The IRS initially took the position that, while HMOs could
qualify for tax-exempt status as social welfare organizations
under section 501(c) (4), they could not qualify as charitable
organizations under section 501(c) (3) because the preferential
treatment provided to members/subscribers represented private,
rather than public, benefit. However, the United States Tax
Court rejected this position in Sound Health Association v.
Commissioner, 71 T.C. 158 (1978). The Court held that the
programs and facilities of the staff model HMO benefited the
community because its membership class was so open as to be
practically unlimited; where possible membership is so broad,
benefit to the membership constitutes benefit to the community.

In response to the Soun Association decision, the
IRS issued several GCMs identifying certain factors which
differentiate HMOs exempt under section 501(c) (3) from other
HMOs.'° In GCM 39828 (August 30, 1990), for example, the IRS
stated that the characteristics of an HMO eligible for tax-

5 Both State and Federal law regulate the operation of
HMOs. For Federal purposes, the Health Maintenance Organization
Act of 1973, Pub. L. No. 93-222, codified as amended at 42 U.S.C.
300e - 300e17, defines a health maintenance organization and
prescribes the manner in which such organizations must be organized
and provide health services to be qualified under the Act and
eligible for certain Federal developmental loans, grants and
guarantees. In GCM 39829, the IRS suggested that an HMO’s
qualification under the Act could be considered as evidence of
community benefit, noting that the Act imposes requirements in the
areas of quality assurance, community rating and continuation of
coverage that tend to suggest that the HMO’s operations would
benefit the community.

° See GCM 39829 (August 30, 1990).

0 Although general counsel memoranda may not be relied upon
as precedent, these documents are made public under section 6110 of
the Code and may be indicative of the IRS’ position on particular
issues.



20
Special rules applicable to certain taxable insurance companies

Some might argue that the present-law special rules under
Code section 833 (enacted in 1986) for Blue Cross and Blue Shield
organizations that became taxable was intended merely to ease the
transition from tax-exempt to taxable status and should now be
repealed. It could be argued that sufficient time has elapsed
since the 1986 Act changed the tax status of these organizations
for them to adjust to operation as taxable entities, and that
repeal of the special deduction, as provided by the bill, is now
appropriate. Others might assert that this purpose was not
stated in the legislative history, and, in fact, the provision
was not temporary when enacted.



2
DESCRIPTION AND ANALYSIS OF PROVISIONS
Tax Treatment of Organizations Providing Health Care Services and
Related Organizations (secs. 7601-7603 of the bill and secs. 501,
509 and 833 of the Code)

Background and Present Law
Tax-exempt organizations generally

Code section 501(a) provides that certain organizations
listed in sections 501(c) and (d) are exempt from Federal income
tax. Among the organizations listed in section 501(c) are those
organized and operated exclusively for religious, charitable,
scientific, testing for public safety, literary, or educational
purposes, no part of the net earnings of which inures to the
benefit of any private shareholder or individual (sec.

501(c) (3)), and civic leagues and organizations not organized for
profit which are operated exclusively for the promotion of social
welfare (section 501(c) (4)).

Charitable organizations described in section 501(c) (3) are
classified either as public charities or private foundations. In
general, an organization will be classified as a public charity
if it (1) receives significant support (generally more than one
third) in the form of contributions from the general public or
(2) is a church, school or hospital. In addition, section
509 (a) (3) provides that public charities include certain
"support" organizations which are organized and operated
exclusively to benefit one or more specified public or publicly
supported charitable organizations. Public charities are not
subject to the special rules applicable to private foundations,
such as a prohibition against self-dealing and tax on net
investment income, and contributions to public charities are
subject to more liberal deduction rules than are contributions to
private foundations.

Charitable organizations exempt under section 501(c) (3)
receive four major tax benefits: (1) exemption from Federal
income tax; (2) ability to accept tax-deductible contributions;
(3) ability to benefit from tax-exempt financing; and (4)
exemption from certain State and local taxes.? In contrast,
social welfare organizations exempt from Federal income tax under
section 501(c) (4) cannot accept tax-deductible contributions or
use tax-exempt financing, and generally are not exempt from State

2 The extent to which an organization is eligible for
exemption from State and local taxes depends on the laws of the
local jurisdiction; while local exemption is frequently conditioned
upon Federal exempt status, it does not flow automatically from
such status.



13

the amount of care provided. Unlike the "point of service"
situation described above, the HMO in these cases, rather than
the member, controls the decision regarding the appropriate
health care provider.

Fourth, insurance relating to emergency care provided to a
member of an HMO at a location outside such member's area of
residence would not constitute commercial-type insurance. This
exception would apply, for example, when an HMO reimburses health
care providers for the provision of emergency care to HMO
members, outside of their area of residence, irrespective of
whether such providers have a pre-existing arrangement with the
HMO.

Effective date.--These provisions would be effective on the
date of enactment.

Definiti. f taxable pro; t ca ty insurani ompanie:

In general, the bill would redefine the scope of
organizations treated as taxable property and casualty insurance
companies. Under the bill, any organization that is not tax-
exempt, is not a life insurance company, and whose primary and
predominant business activity during the taxable year falls in
one of three categories, would be treated as a property and
Casualty insurance company. The three categories of activities
are: (1) issuing accident and health insurance contracts or
reinsuring accident and health risks; (2) operating as an HMO; or
(3) entering into arrangements to provide or arrange for the
provision of health care services in exchange for fixed payments
or premiums that do not vary depending on the amount of health
care services provided. The bill would modify the "primary and
predominant" requirement in the case of organizations that have,
as a material business activity, the issuing or reinsurance of
accident and health insurance contracts. For such organizations,
the administering of accident and health insurance contracts
would be treated as part of such business activity for purposes
of determining whether the organization’s activities fall within
the scope of category (1) above.

Ef iv te.--This provision would be effective for
taxable years beginning after December 31, 1996.

FS} al 1i 1 fe} tain ta: ei: ran fet ani

The bill would repeal the spetial rules provided under
section 833 to Blue Cross and Blue Shiela organizations and other
eligible organizations, and would provide transition rules for
organizations that become subject to section 833 after the
effective date (generally, taxable years beginning after December
31, 1996). The provision would treat such organizations as
insurance companies, but would not specify that such



15
fair market value of the asset on that date.

The bill would also specify that the above amendments do not
affect the adjusted basis of any asset determined under the
transition rule provided for existing Blue Cross and Blue Shield
organizations in the 1986 Act (i.e., generally, that basis
equalled fair market value as of the first day of the
organization’s taxable year beginning after December 31, 1986).
In addition, the bill would eliminate the requirement that
existing Blue Cross and Blue Shield organizations not experience
any material change in their operations or structure to be
eligible for the basis adjustment, and would further provide
that, on January 1, 1997, such basis adjustment is made
permanent.

Eft ve .--These provisions would generally be
effective for taxable years beginning after December 31, 1996,
subject to the special income inclusion rule (with respect to the
repeal of the 20 percent reduction), the phase-out rule for
certain organizations (with respect to the repeal of the special
deduction for 25 percent of claims), and the transition rules
described above.

scussi of I 2.

Tax-exempt status of certain organizations

In general, tax exemption is a form of subsidy administered
through the tax system (sometimes referred to as a "tax
expenditure"). It is granted to, among other organizations,
certain private organizations that conduct activities which
Congress deems to further worthy public objectives.

As a threshold matter, it is important to assess whether the
subsidization of the operation of hospitals and HMOs, as well as
regional health alliances, through tax expenditures, rather than
through direct outlays or other means of finance, is appropriate.
In general, such subsidization means that the true cost of such
activities appears understated in relation to the cost of other
goods and services because they do not appear as outlays in
budget reporting. In addition, such tax expenditures are not
subject to the annual appropriations process.

The desirability of tax exemption also must be evaluated in
the context of the overall health care proposal. As described
above, under present law, the provision of medical care and
operation of a nonprofit hospital in a manner that satisfies the
"community benefit" standard is considered to further
"charitable" objectives. Although this community benefit
standard evolved in response to the expanded Federal role in
health care financing through programs such as Medicare and
Medicaid, payment for medical care remained largely the province



INTRODUCTION

The Subcommittee on Select Revenue Measure of the House
Committee on Ways and Means has scheduled public hearings on
selected tax provisions in the Administration's proposed Health
Security Act (H.R. 3600). The first of these hearings is
scheduled for December 14, 1993, and will focus on the tax
treatment of health care organizations. Additional days of
hearings on other tax provisions will be announced at a later
date.

This document,' prepared by the staff of the Joint Committee
on Taxation, provides a description of present law and a
description and analysis of the provisions of H.R. 3600 relating
to the tax treatment of health care organizations and related
organizations (subtitle F of Title VII of the bill).

‘This document may be cited as follows: Joint Committee on

Taxation, Description and Analysis of Provisions in the Health

Security Act (H.R. 3600) Relating to the Tax Treatment of
iz. s___Providin eal ar rvic an elat

Organ tions (JCX-15-93), December 13, 1993.



CONTENTS

INTRODUCTION . - 2... ee ee ee
DESCRIPTION AND ANALYSIS OF PROVISIONS

Tax Treatment of Organizations Providing Health Care
Services and Related Organizations ....



11

to qualify as tax-exempt charitable organizations under section
501(c) (3).

In particular, the bill would amend the Code specifically to
require that, in order for the provision of health care services
to constitute a charitable activity for purposes of section
501(c) (3), the organization providing such services must
periodically assess the health care needs of its community and
develop a plan to meet those needs. Such assessment and plan
development must take place at least annually and must include
the participation of community representatives.

In addition, the bill would provide that an HMO seeking tax-
exempt status under section 501(c) (3) must furnish health care
services to its members at its own facilities through health care
professionals who do not provide substantial health care services
other than on behalf of such organization.

The bill would further provide that organizations which
serve as parent holding companies for hospitals or medical
research organizations constitute public charities rather than
private foundations. Thus, the bill would add to the list of
organizations described in section 509(a) any organization which
is organized and operated for the benefit of, and which directly
or indirectly controls, (1) a hospital, the principal purpose or
function of which is the provision of medical or hospital care or
medical education or medical research; or (2) a medical research
organization if such organization is directly engaged in the
continuous active conduct of medical research in conjunction with
a hospital and, during the calendar year in which the
contribution is made, such organization is committed to spend
such contribution for medical research not later than the
beginning of the fifth calendar year beginning after the date
such contribution is made.

Finally, section 7603 of the bill would add the to-be-
established regional alliances described in section 1301 of the
bill to the list of tax-exempt organizations set forth in Code
section 501(c).

Effective date.--The provisions regarding the definition of
Charitable activities of medical service providers and HMOs would
be effective January 1, 1995. The provision regarding the exempt
status of regional alliances would apply to taxable years
beginning after the date of enactment, and the provision
regarding the treatment of parent organizations of health care
providers would take effect on the date of enactment.

Ins ce td of tax- tt iz. 8

Under the bill, health insurance provided by an HMO would be
treated as commercial-type insurance if such insurance relates to



14
organizations be treated as stock companies.

The bill would repeal the special exception to the 20-
percent reduction with respect to unearned premium reserves. The
bill would require inclusion in income ratably, over a six-year
period following the effective date, of 20 percent of the
unearned premium reserve outstanding at the end of the most
recent taxable year beginning before January 1, 1997. The
inclusion would be required at the rate of 3-1/3 percent of such
outstanding unearned premium reserve in each of the first six
taxable years beginning after December 31, 1996.

The bill would also repeal the special deduction for 25
percent of claims. A special phase-out rule would apply to an
organization that meets the community-service-related
requirements of present law for each of its taxable years
beginning in 1995 and 1996. For such organizations, the
deduction would be phased out at a specified rate over the
organization’s first two years following the effective date; 67
percent of the otherwise allowable amount of the special
deduction would be allowed for such an organization’s taxable
year beginning in 1997, and 33 percent would be allowed for its
taxable year beginning in 1998. As under present law, the
deduction would not be allowable during the phase-out period in
determining the organization’s alternative minimum taxable
income.

The bill would provide transition rules for organizations
that become subject to section 833, as amended, after the
effective date (generally, taxable years beginning after December
31, 1996). For an organization that is not tax-exempt for its
last taxable year beginning before January 1, 1997 (and is taxed
other than under the property and casualty insurance company
regime for taxable years beginning in 1992 through 1996), the
amendments to section 833 would be treated as a change in method
of accounting, and all adjustments required to be taken into
account under section 481 would be taken into account in one
taxable year, i.e., the company’s first taxable year beginning
after December 31, 1996. No special transition rule would apply
to organizations that treat themselves as subject to tax under
the property and casualty insurance company regime for taxable
years beginning in 1992 through 1996.

For an organization that is tax-exempt for its last taxable
year beginning before January 1, 1997, no adjustment would be
taken into account under section 481 or any other provision for
the company’s first taxable year beginning after December 31,
1996, on account of a change in method of accounting required by
the amendments to section 833. In addition, for purposes of
determining gain or loss, the adjusted basis of any asset held by
such an organization on the first day of its first taxable year
beginning after December 31, 1996, would be deemed equal to the