Part I. Rulings — Internal Revenue Bulletin 1997-18

333), the IRS announced that it would raise the receipt threshold of § 1.274– 5T(c)(2)(iii)(B) from $25 to $75, effective for expenses incurred on or after October 1, 1995. The temporary regulations effect this amendment by changing ‘‘$25’’ in § 1.274–5T(c)(2)(iii)(B) to ‘‘$75.’’ This change is applicable to both deductions and reimbursement arrangements and is expected to reduce the recordkeeping burden on affected taxpayers, including individuals and small businesses.

Definition of an ‘‘adequate accounting’’ to the employer

An employee who is reimbursed under a reimbursement or other expense allowance arrangement for expenses covered by section 274(d) must make an ‘‘adequate accounting’’ to the employer for the reimbursed expenses. Section 1.274–5T(f)(4) specifies that, as part of an adequate accounting, the employee must submit substantiation to the employer that satisfies the requirements of § 1.274–5T(c). Notice 95–50 also solicited comments on whether changes should be made to the substantiation requirements of the adequate accounting rules in § 1.274–5T. Comments received related primarily to the adequate accounting rules and the substantiation requirements in general.

Submission and retention of documentary evidence

A number of commentators, particularly federal government agencies, complained of the administrative burden and cost of storing large quantities of paper receipts. Some comments proposed that the employer should be allowed to dispose of the documentary evidence after an employee has made an adequate accounting, or return the documentary evidence to the employee for retention. Other comments suggested that submission by an employee of an expense voucher alone, without documentary evidence, should be considered an adequate accounting.

With the increase in the receipt threshold to $75, and the use of electronic document transmission and retention (discussed below), the necessity for storing large quantities of paper records is significantly reduced. Nonetheless, the temporary regulations respond to the concerns expressed by these comments by amending § 1.274–5T(f)(4) to authorize the Commissioner to prescribe rules

Section 42.—Low-Income Housing Credit

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of May 1997. See Rev. Rul. 97–19, page 11.

Section 274.—Disallowance of Certain Entertainment, Etc., Expenses

26 CFR 1.274–5T: Substantiation requirements (temporary).

T.D. 8715

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 602

Substantiation of business expenses for travel, entertainment, gifts and listed property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains amendments to temporary regulations relating to the requirement that business expenses for travel, entertainment, gifts, or listed property be substantiated by documentary evidence (such as a receipt). The regulations affect persons making or receiving reimbursements for travel, entertainment, gifts, or listed property. The text of these temporary regulations also serves as the text of REG–209785–95, page 46.

DATES: These temporary regulations are effective March 25, 1997. Applicability: These temporary regulations are applicable to expenses paid or incurred after September 30, 1995.

FOR FURTHER INFORMATION CONTACT: Donna M. Crisalli at (202) 622– 4920 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

These regulations are being issued without prior notice and public comment pursuant to the Administrative Procedure Act (5 U.S.C. 553). For this reason, the collection of information contained in these regulations has been reviewed and, pending receipt and evaluation of public comments, approved by the Office of Management and Budget (OMB) under

control number 1545–0771. Responses to this collection of information are required for a taxpayer to deduct certain business expenses or to substantiate certain reimbursements of business expenses.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number.

For further information concerning this collection of information, and where to submit comments on the collection of information and the accuracy of the estimated burden, and suggestions for reducing the burden, please refer to the preamble in the cross-reference notice of proposed rulemaking published in the Proposed Rules section of this issue of the Federal Register.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Background and Explanation of Provisions

Receipt threshold

Section 274(d) disallows a trade or business deduction under section 162 for any traveling (including meals and lodging), entertainment, gift, or listed property expense, unless the taxpayer substantiates the elements of the expense by adequate records or by sufficient evidence. Under § 1.274–5T(c) of the temporary Income Tax Regulations, a taxpayer must maintain two types of records to satisfy the ‘‘adequate records’’ requirement: (1) a summary of expenses (account book, diary, log, statement of expense, trip sheets, or other similar record), sometimes called an expense account or expense voucher, and (2) documentary evidence (such as receipts or paid bills). Together, these records must establish the elements of amount, time, place, and business purpose (and for gifts and entertainment, business relationship of recipient or persons entertained) for each expenditure or use.

Section 1.274–5T(c)(2)(iii) generally requires that a taxpayer have a receipt or other documentary evidence to substantiate (A) any expenditure for lodging and (B) any other expenditure of $25 or more. In Notice 95–50 (1995–2 C.B.

modifying the substantiation requirements for an adequate accounting by an employee to an employer. Under the amendment, the Commissioner could publish rules defining the circumstances (including the use of specified internal controls) under which an employee may make an adequate accounting to his employer by submitting an expense account alone, without the necessity of submitting documentary evidence (such as receipts). This change is expected to reduce the recordkeeping burden for employers and employees. These rules would not change the substantiation requirements of § 1.274–5T(c) for deductions.

Maintenance of adequate records in electronic form

Some commentators suggested that taxpayers should be permitted to obtain and maintain records substantiating expenses under section 274(d) in electronic form. The temporary regulations make no change to the current regulations, which do not require that the records be in paper form. Rev. Proc. 91–59 (1991–2 C.B. 841), provides procedures for maintaining tax records in electronic form. Section 3.08 of Rev. Proc. 91–59 states that the procedures apply to documentation required by section 274(d).

Types of records that constitute acceptable documentary evidence

Some commentators suggested that credit card charge records should be considered acceptable documentary evidence of travel expenses, including lodging. They noted, however, that § 1.274–5T(c)(2)(iii) requires that documentary evidence of lodging must show separate amounts for charges such as lodging, meals, and telephone calls. A credit card statement or record of charge, unlike a hotel bill, normally will not segregate lodging and other expenses, such as meals and entertainment subject to the section 274(n) partial deduction disallowance, or personal expenses (such as personal phone calls or gift purchases) that may not be deducted. Therefore, such a credit card statement or record of charge alone will not constitute acceptable documentary evidence of a lodging expense.

The commentators proposed addressing this problem by using statistical sampling, conducted either by the IRS or by taxpayers, to establish a breakdown of expenses on hotel bills. One comment suggested that sampling could

form a basis for a ‘‘safe harbor’’ percentage or percentages (e.g., by industry or size of company) of hotel bills that would be deemed to represent the various types of possible expenses. Another comment suggested that the IRS adopt a mechanical test based on statistical sampling to make a reasonable allocation of the total hotel charge to meals.

The temporary regulations make no change to the current documentary evidence requirements for lodging expenses. Because of the large number of expenses that can be charged to hotel bills, and extensive variation from traveler to traveler in the types of expenses charged to hotel bills, any attempt to establish percentages for allocating hotel bills to lodging and other fully deductible business expenses, meals and entertainment, and personal expenses is considered impracticable.

A comment requested that the IRS clarify whether statements provided to travelers by airlines in lieu of tickets can constitute documentary evidence of travel. The current regulations are sufficiently flexible to permit use of a variety of forms of documentary evidence.

Other Comments in Response to Notice 95–50

Substantiation of business purpose

A commentator suggested that the regulations be revised to permit an employee to initially substantiate business purpose to the employer orally, for later entry into the expense processing system. The current regulations do not preclude an initial oral substantiation of business purpose which is reduced to writing no later than the time of the employee’s final accounting to the employer.

Post-expenditure verification procedures

A comment suggested that the regulations be revised to permit an employer to conduct a post-expenditure review of only a statistical sampling, as opposed to 100%, of expense vouchers.

Section 1.274–5T(f)(5)(iii) states that an employee who makes an adequate accounting to his employer will not again be required to substantiate such expenses, unless the employer’s accounting procedures are not adequate or it cannot be determined that such procedures are adequate. The district director will determine whether the employer’s accounting procedures are adequate by considering all the facts and circum

stances, including the employer’s use of internal controls. The employer’s accounting procedures should include a requirement that an expense account be verified and approved by a reasonable person other than the person incurring the expense. To the extent the employer fails to maintain adequate accounting procedures, the district director may require the employee to separately substantiate his expense account information.

Section 1.274–5T(f)(5)(iii) cites postexpenditure review of employees’ expense accounts as an internal control that should normally be employed. However, whether the employer’s postexpenditure review procedures are appropriate is a matter within the discretion of the district director, based on a review of all the facts and circumstances.

De minimis exception to substantiation requirements

A comment proposed that employees receiving $1000 or less per year in reimbursed expenses be exempted from the requirement to substantiate the elements of the expenses, other than business purpose, to the employer. In view of the other changes made by the temporary regulations that will lessen a taxpayer’s recordkeeping burden, such as the increase in the receipt threshold, the temporary regulations do not incorporate this suggestion.

Department of Labor substantiation requirements for plan trustees

A comment requested the IRS to coordinate with the Department of Labor to establish common substantiation requirements under ERISA for travel by multi-employer plan trustees. Modifications to conform the substantiation requirements under ERISA to those provided in the temporary regulations are outside the scope of the section 274(d) regulations.

Increase in limit on deduction for gifts

A comment requested that the $25 limit on the deduction for gifts contained in section 274(b) be increased to $75. The IRS has no discretion to raise this statutory limit.

Use of full federal per diem method to substantiate travel for deduction purposes

A comment suggested that selfemployed individuals and unreimbursed

employees should be entitled to substantiate lodging expenses for deduction purposes by means of the ‘‘high-low’’ per diem method. Rev. Proc. 96–64 (1996–53 I.R.B. 52), permits this substantiation method for employee reimbursements only. This suggestion is outside the scope of this revision to the temporary regulations.

Special Analyses

It has been determined that these temporary regulations are not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It is hereby certified that these regulations do not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that, by increasing the receipt threshold from $25 to $75, these regulations reduce the existing recordkeeping requirements of taxpayers, including small entities. The regulations do not otherwise significantly alter the reporting or recordkeeping duties of small entities. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Internal Revenue Code, these temporary regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Drafting Information

The principal author of these regulations is Donna M. Crisalli, Office of the Assistant Chief Counsel (Income Tax and Accounting). However, other personnel from the IRS and Treasury Department participated in their development.

- - - -

Adoption of Amendments to the Regula- tions

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding an entry in numerical order to read as follows:

Authority: 26 U.S.C. 7805 - -
Section 1.274–5T also issued under 26 U.S.C. 274(d). - - Par. 2. An undesignated centerheading is added immediately following § 1.280H–1T to read as follows:

- - - - (f) - - (4) - - - (i) In general. - -

(ii) Procedures for adequate ac- counting without documentary evidence. The Commissioner may, in his discretion, prescribe rules under which an employee may make an adequate accounting to his employer by submitting an account book, log, diary, etc., alone, without submitting documentary evidence.

(iii) Employer. For purposes of this section, the term employer includes an agent of the employer or a third party payor who pays amounts to an employee under a reimbursement or other expense allowance arrangement.

- - - -

Taxable Years Beginning Prior to January 1, 1986

§ 1.274–5 redesignated as § 1.274–5A

Par. 3. Section 1.274–5 is redesignated as § 1.274–5A and added immediately following the undesignated centerheading ‘‘Taxable Years Beginning Prior to January 1, 1986’’.

Par. 4. Section 1.274–5T is amended by:

Revising the first sentence of paragraph (c)(2)(iii)(B).
Redesignating the text of paragraph (f)(4) as paragraph (f)(4)(i).
Adding a paragraph heading for paragraph (f)(4)(i).
Adding paragraphs (f)(4)(ii) and (f)(4)(iii).

The revisions and additions read as follows:

§ 1.274–5T Substantiation requirements (temporary).

- - - - (c) - - (2) - - (iii) - - (B) Any other expenditure of $75 or

more ($25 or more for expenditures incurred before October 1, 1995) except, for transportation charges, documentary evidence will not be required if not readily available, provided, however, that the Commissioner, in his discretion, may prescribe rules waiving such requirements in circumstances where he determines it is impracticable for such documentary evidence to be required.

PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 5. The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 6. In § 602.101, paragraph (c) is amended by:

Removing the following entry from the table:

CFR part or section where identified and described

Current OMB

control No.

- - - 1.274–5 . . . . . . . . . . 1545–0139

1545–0771

Adding an entry in numerical order to the table to read as follows:

CFR part or section where identified and described

Current OMB

control No.

- - - 1.274–5A. . . . . . . . . 1545–0139

1545–0771

Margaret Milner Richardson, Commissioner of Internal Revenue.

Approved February 14, 1997.

Donald C. Lubick, Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on March 24, 1997, 8:45 a.m., and published in the issue of the Federal Register for March 25, 1997, 62 F.R. 13988)

Section 280G.—Golden Parachute Payments

Federal short-term, mid-term, and long-term rates are set forth for the month of May 1997. See Rev. Rul. 97–19, page 11.

Section 382.—Limitation on Net Operating Loss Carryforwards and Certain Built-In Losses Following Ownership Change

The adjusted federal long-term rate is set forth for the month of May 1997. See Rev. Rul. 97–19, page 11.

Section 412.—Minimum Funding Standards

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of May 1997. See Rev. Rul. 97–19, page 11.

Section 467.—Certain Payments for the Use of Property or Services

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of May 1997. See Rev. Rul. 97–19, page 11.

Section 468.—Special Rules for Mining and Solid Waste Reclamation and Closing Costs

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of May 1997. See Rev. Rul. 97–19, page 11.

Section 483.—Interest on Certain Deferred Payments

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of May 1997. See Rev. Rul. 97–19, page 11.

Section 501.—Exemption From Tax on Corporations, Certain Trusts, Etc.

26 CFR 1.501(c)(3)–1: Organizations organized and operated for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or for the prevention of cruelty to children or animals.

Tax consequences of physician re- cruitment incentives provided by hos- pitals described in section 501(c)(3) of the Code. This ruling provides examples illustrating whether nonprofit hospitals that provide incentives to physicians to join their medical staffs or to provide medical services in the community violate the requirements for exemption as organizations described in section 501(c)(3) of the Code.

Rev. Rul. 97–21

ISSUE

Whether, under the facts described below, a hospital violates the requirements for exemption from federal income tax as an organization described in § 501(c)(3) of the Internal Revenue Code when it provides incentives to recruit private practice physicians to join its medical staff or to provide medical services in the community.

FACTS

All of the hospitals in the situations described below have been recognized as exempt from federal income tax under § 501(a) as organizations described in § 501(c)(3) and operate in accordance with the standards for exemption set forth in Revenue Ruling 69–545, 1969–2 C.B. 117. The physicians described in the following recruiting transactions do not have substantial influence over the affairs of the hospitals that are recruiting them. Therefore, they are not disqualified persons as defined in § 4958, nor do they have any personal or private interest in the activities of the organizations that would subject them to the inurement proscription of § 501(c)(3). Furthermore, in Situations 1, 2, and 4, the physicians have no pre-existing relationship with the hospital or the members of its board. For purposes of this revenue ruling, the physician recruiting activities described in Situations 1, 2, 3, and 4 are assumed to be lawful. However, because the Internal Revenue Service does not have jurisdiction regarding whether the activities described in Situations 1, 2, 3, and 4 are lawful under the Medicare and Medicaid anti-kickback statute, 42 U.S.C. § 1320a–7b(b), taxpayers may not rely upon the facts or assumptions described in this ruling for purposes relating to that statute.

Situation 1

Hospital A is located in County V, a rural area, and is the only hospital within a 100 mile radius. County V has been designated by the U.S. Public Health Service as a Health Professional Shortage Area for primary medical care professionals (a category that includes obstetricians and gynecologists). Physician M recently completed an ob/gyn residency and is not on Hospital A’s medical staff. Hospital A recruits Physician M to establish and maintain a full-time private ob/gyn practice in its service area and become a member of its medical staff. Hospital A provides Physician M a recruitment incentive package pursuant to a written agreement negotiated at arm’s-length. The agreement is in accordance with guidelines for physician recruitment that Hospital A’s Board of Directors establishes, monitors, and reviews regularly to ensure that recruiting practices are consistent with Hospital A’s exempt purposes. The agreement was approved by the committee appointed by Hospital A’s

Board of Directors to approve contracts with hospital medical staff. Hospital A does not provide any recruiting incentives to Physician M other than those set forth in the written agreement.

In accordance with the agreement, Hospital A pays Physician M a signing bonus, Physician M’s professional liability insurance premium for a limited period, provides office space in a building owned by Hospital A for a limited number of years at a below market rent (after which the rental will be at fair market value), and guarantees Physician M’s mortgage on a residence in County V. Hospital A also lends Physician M practice start-up financial assistance pursuant to an agreement that is properly documented and bears reasonable terms.

Situation 2

Hospital B is located in an economically depressed inner-city area of City W. Hospital B has conducted a community needs assessment that indicates both a shortage of pediatricians in Hospital B’s service area and difficulties Medicaid patients are having obtaining pediatric services. Physician N is a pediatrician currently practicing outside of Hospital B’s service area and is not on Hospital B’s medical staff. Hospital B recruits Physician N to relocate to City W, establish and maintain a full-time pediatric practice in Hospital B’s service area, become a member of Hospital B’s medical staff, and treat a reasonable number of Medicaid patients. Hospital B offers Physician N a recruitment incentive package pursuant to a written agreement negotiated at arm’s-length and approved by Hospital B’s Board of Directors. Hospital B does not provide any recruiting incentives to Physician N other than those set forth in the written agreement.

Under the agreement, Hospital B reimburses Physician N for moving expenses as defined in § 217(b), reimburses Physician N for professional liability ‘‘tail’’ coverage for Physician N’s former practice, and guarantees Physician N’s private practice income for a limited number of years. The private practice income guarantee, which is properly documented, provides that Hospital B will make up the difference to the extent Physician N practices fulltime in its service area and the private practice does not generate a certain level of net income (after reasonable expenses of the practice). The amount guaranteed falls within the range reflected in re

gional or national surveys regarding income earned by physicians in the same specialty.

Situation 3

Hospital C is located in an economically depressed inner city area of City X. Hospital C has conducted a community needs assessment that indicates indigent patients are having difficulty getting access to care because of a shortage of obstetricians in Hospital C’s service area willing to treat Medicaid and charity care patients. Hospital C recruits Physician O, an obstetrician who is currently a member of Hospital C’s medical staff, to provide these services and enters into a written agreement with Physician O. The agreement is in accordance with guidelines for physician recruitment that Hospital C’s Board of Directors establishes, monitors, and reviews regularly to ensure that recruiting practices are consistent with Hospital C’s exempt purpose. The agreement was approved by the officer designated by Hospital C’s Board of Directors to enter into contracts with hospital medical staff. Hospital C does not provide any recruiting incentives to Physician O other than those set forth in the written agreement. Pursuant to the agreement, Hospital C agrees to reimburse Physician O for the cost of one year’s professional liability insurance in return for an agreement by Physician O to treat a reasonable number of Medicaid and charity care patients for that year.

Situation 4

Hospital D is located in City Y, a medium to large size metropolitan area. Hospital D requires a minimum of four diagnostic radiologists to ensure adequate coverage and a high quality of care for its radiology department. Two of the four diagnostic radiologists currently providing coverage for Hospital D are relocating to other areas. Hospital D initiates a search for diagnostic radiologists and determines that one of the two most qualified candidates is Physician P.

Physician P currently is practicing in City Y as a member of the medical staff of Hospital E (which is also located in City Y). As a diagnostic radiologist, Physician P provides services for patients receiving care at Hospital E, but does not refer patients to Hospital E or any other hospital in City Y. Physician P is not on Hospital D’s medical staff. Hospital D recruits Physician P to join its medical staff and to provide coverage

for its radiology department. Hospital D offers Physician P a recruitment incentive package pursuant to a written agreement, negotiated at arm’s-length and approved by Hospital D’s Board of Directors. Hospital D does not provide any recruiting incentives to Physician P other than those set forth in the written agreement.

Pursuant to the agreement, Hospital D guarantees Physician P’s private practice income for the first few years that Physician P is a member of its medical staff and provides coverage for its radiology department. The private practice income guarantee, which is properly documented, provides that Hospital D will make up the difference to Physician P to the extent the private practice does not generate a certain level of net income (after reasonable expenses of the practice). The net income amount guaranteed falls within the range reflected in regional or national surveys regarding income earned by physicians in the same specialty.

Situation 5

Hospital F is located in City Z, a medium to large size metropolitan area. Because of its physician recruitment practices, Hospital F has been found guilty in a court of law of knowingly and willfully violating the Medicare and Medicaid anti-kickback statute, 42 U.S.C. § 1320a–7b(b), for providing recruitment incentives that constituted payments for referrals. The activities resulting in the violations were substantial.

LAW

Section 501(c)(3) provides, in part, for the exemption from federal income tax of corporations organized and operated exclusively for charitable, scientific, or educational purposes, provided no part of the organization’s net earnings inures to the benefit of any private shareholder or individual.

Section 1.501(c)(3)–1(d)(2) of the Income Tax Regulations provides that the term ‘‘charitable’’ is used in § 501(c)(3) in its generally accepted legal sense. The promotion of health has long been recognized as a charitable purpose. See Restatement (Second) of Trusts, §§ 368, 372 (1959); 4A Austin W. Scott and William F. Fratcher, The Law of Trusts §§ 368, 372 (4th ed. 1989); and Rev. Rul. 69–545, 1969–2 C.B. 117. Under the common law of charitable trusts, all such organizations are subject to the

requirement that their purposes may not be illegal. See Restatement (Second) of Trusts § 377 (1959); 4A Austin W. Scott and William F. Fratcher, The Law of Trusts § 377 (4th ed. 1989); Bob Jones University v. U.S., 461 U.S. 574, 591 (1983); Rev. Rul. 80–278, 1980–2 C.B. 175; Rev. Rul. 80–279, 1980–2 C.B. 176.

Section 1.501(c)(3)–1(c)(2) states that an organization is not operated exclusively for charitable purposes if its net earnings inure in whole or in part to the benefit of private shareholders or individuals.

Section 1.501(a)–1(c) defines ‘‘private shareholder or individual’’ as referring to persons having a personal and private interest in the activities of the organization.

Section 1.501(c)(3)–1(d)(1)(ii) states that an organization is not organized exclusively for any of the purposes specified in § 501(c)(3) unless it serves public, rather than private interests. Thus, an organization applying for tax exemption under § 501(c)(3) must establish that it is not organized or operated for the benefit of private interests.

Rev. Rul. 69–545, 1969–2 C.B. 117, holds that a non-profit hospital that benefits a broad cross section of its community by having an open medical staff and a board of trustees broadly representative of the community, operating a full-time emergency room open to all regardless of ability to pay, and otherwise admitting all patients able to pay (either themselves, or through third party payers such as private health insurance or government programs such as Medicare) may qualify as an organization described in § 501(c)(3). The same standard has been used by the courts as the basis for evaluating whether health maintenance organizations qualify for exemption as organizations described in § 501(c)(3). Sound Health Association v. Commissioner, 71 T.C. 158 (1978), acq. 1981–2 C.B. 2; Geisinger Health Plan v. Commissioner, 985 F.2d 1210 (3rd Cir. 1993), rev’g 62 T.C.M. (CCH) 1656 (1991). Rev. Rul. 72–559, 1972–2 C.B. 247, holds that an organization that provides subsidies to recent law school graduates during the first three years of their practice to enable them to establish legal practices in economically depressed communities that have a shortage of available legal services and to provide free legal service to needy members of the community may qualify as an organization described in § 501(c)(3).

Rev. Rul. 73–313, 1973–2 C.B. 174, holds that attracting a physician to a community that had no available medical services furthered the charitable purpose of promoting the health of the community. In Rev. Rul. 73–313, residents of an isolated rural community had to travel a considerable distance to obtain care. Faced with the total lack of local services, the community formed an organization to raise funds and build a medical office building to attract a doctor to the locality. (No hospitals or existing medical practices were involved.) The ruling states that certain facts are particularly relevant: (1) the demonstrated need for a physician to avert a real and substantial threat to the community; (2) evidence that the lack of a suitable office had impeded efforts to attract a physician; (3) the arrangements were completely at arm’s-length; and (4) there was no relationship between any person connected with the organization and the recruited physician. The ruling states that, under all the circumstances, the arrangement used to induce the doctor to locate a practice in the area ‘‘bear[s] a reasonable relationship to promotion and protection of the health of the community’’ and any private benefit to the physician is incidental to the public purpose achieved. It concludes that the activity furthers a charitable purpose and the organization qualifies for exemption as an organization described in § 501(c)(3).

Rev. Rul. 75–384, 1975–2 C.B. 204, holds that an organization whose primary activity is sponsoring antiwar protest demonstrations in which demonstrators are urged to commit violations of local ordinances and breaches of the public order does not qualify as an organization described in § 501(c)(3) because its activities demonstrate an illegal purpose that is inconsistent with charitable purposes.

Rev. Rul. 80–278, 1980–2 C.B. 175, and Rev. Rul. 80–279, 1980–2 C.B. 176, discuss the qualification as organizations described in § 501(c)(3) of organizations that conduct environmental litigation and environmental dispute mediation. In holding that these organizations may qualify, the rulings state that, in determining whether an organization meets the operational test, the issue is whether the particular activity undertaken by the organization appropriately furthers the organization’s exempt purpose. The rulings state that an organization’s activities will be considered permissible under § 501(c)(3) if the

following conditions are met: (1) the purpose of the organization is charitable; (2) the activities are not illegal, contrary to a clearly defined and established public policy, or in conflict with express statutory restrictions; and (3) the activities are in furtherance of the organization’s exempt purpose and are reasonably related to the accomplishment of that purpose.

ANALYSIS

In order to meet the requirements of § 501(c)(3), a hospital that provides recruitment incentives to physicians must provide those incentives in a manner that does not cause the organization to violate the operational test of § 1.501(c)(3)–1. Whether the recruitment incentives cause the organization to violate the operational test is determined based on all relevant facts and circumstances. When a § 501(c)(3) hospital recruits a physician for its medical staff who is to perform services for or on behalf of the organization, the organization meets the operational test by showing that, taking into account all of the benefits provided the physician by the organization, the organization is paying reasonable compensation for the services the physician is providing in return. A somewhat different analysis must be applied when a § 501(c)(3) hospital recruits a physician for its medical staff to provide services to members of the surrounding community but not necessarily for or on behalf of the organization. In these cases, a violation will result from a failure to comply with any of the following four requirements:

First, the organization may not engage in substantial activities that do not further the hospital’s exempt purposes or that do not bear a reasonable relationship to the accomplishment of those purposes. As discussed in Rev. Rul. 80–278 and Rev. Rul. 80–279, in determining whether an organization meets the operational test, the issue is whether the particular activity undertaken by the organization is appropriately in furtherance of the organization’s exempt purpose.

Second, the organization must not engage in activities that result in inurement of the hospital’s net earnings to a private shareholder or individual. An activity may result in inurement if it is structured as a device to distribute the net earnings of the hospital. See Lorain

Avenue Clinic v. Commissioner, 31 T.C. 141 (1958); Birmingham Business Col- lege, Inc. v. Commissioner, 276 F.2d 476 (5th Cir. 1960). Third, the organization may not engage in substantial activities that cause the hospital to be operated for the benefit of a private interest rather than public interest so that it has a substantial non-exempt purpose. Section 1.501(c)(3)–1(d)(1)(ii). Finally, the organization may not engage in substantial unlawful activities. As discussed in Rev. Rul. 75–384, Rev. Rul. 80–278, and Rev. Rul. 80–279, the conduct of an unlawful activity is inconsistent with charitable purposes. An organization conducts an activity that is unlawful, and therefore not in furtherance of a charitable purpose, if the organization’s property is to be used for an objective that is in violation of the criminal law. Activities can accomplish an unlawful purpose through either direct or indirect means.

Situation 1

Like the organization described in Rev. Rul. 73–313, Hospital A has objective evidence demonstrating a need for obstetricians and gynecologists in its service area and has engaged in physician recruitment activity bearing a reasonable relationship to promoting and protecting the health of the community in accordance with Rev. Rul. 69–545. As with the subsidies provided to the recent law school graduates in Rev. Rul. 72–559, the payment of a bonus, the guarantee of a mortgage, the reimbursement of professional liability insurance and provision of subsidized office space for a limited time, and the lending of start-up financial assistance as recruitment incentives are reasonably related to causing Physician M to become a member of Hospital A’s medical staff and to establish and maintain a full-time private ob/gyn practice in Hospital A’s service area. The provision of the incentives under the circumstances described furthers the charitable purposes served by the hospital and is consistent with the requirements for exemption as an organization described in § 501(c)(3).

Situation 2

Like Hospital A in Situation 1, Hospital B has objective evidence demonstrating a need for pediatricians in its service area and has engaged in physician recruitment activity bearing a reasonable

relationship to promoting and protecting the health of the community in much the same manner as the organization described in Rev. Rul. 73–313. As with the recruitment incentive package provided by Hospital A, the payment of moving expenses, the reimbursement of professional liability ‘‘tail’’ coverage, and the provision of a reasonable private practice income guarantee as recruitment incentives are reasonably related to causing Physician N to become a member of Hospital B’s medical staff and to establish and maintain a full-time private pediatric practice in Hospital B’s service area. Thus, the recruitment activity described furthers the charitable purposes served by the hospital and is consistent with the requirements for exemption as an organization described in § 501(c)(3).

Situation 3

In accordance with the standards for exemption set forth in Rev. Rul. 69–545, Hospital C admits and treats Medicaid patients on a non-discriminatory basis. Hospital C has identified a shortage of obstetricians willing to treat Medicaid patients. The payment of Physician O’s professional liability insurance premiums in return for Physician O’s agreement to treat a reasonable number of Medicaid and charity care patients is reasonably related to the accomplishment of Hospital C’s exempt purposes. Because the amount paid by Hospital C is reasonable and any private benefit to Physician O is outweighed by the public purpose served by the agreement, the recruitment activity described is consistent with the requirements for exemption as an organization described in § 501(c)(3).

Situation 4

Hospital D has objective evidence demonstrating a need for diagnostic radiologists to provide coverage for its radiology department so that it can promote the health of the community. The provision of a reasonable private practice income guarantee as a recruitment incentive that is conditioned upon Physician P obtaining medical staff privileges and providing coverage for the radiology department is reasonably related to the accomplishment of the charitable purposes served by the hospital. A significant fact in determining that the community benefit provided by the activity outweighs the private benefit provided to Physician P is the determi

nation by the Board of Directors of Hospital D that it needs additional diagnostic radiologists to provide adequate coverage and to ensure a high quality of medical care. The recruitment activity described is consistent with the requirements for exemption as an organization described in § 501(c)(3).

Situation 5

Hospital F has engaged in physician recruiting practices resulting in a criminal conviction. As in Rev. Rul. 75–384, the recruiting activities were intentional and criminal, not isolated or inadvertent violations of a regulatory statute. An organization that engages in substantial unlawful activities, including activities involving the use of the organization’s property for an objective that is in violation of criminal law, does not qualify as an organization described in § 501(c)(3). Because Hospital F has knowingly and willfully conducted substantial activities that are inconsistent with charitable purposes, it does not comply with the requirements of § 501(c)(3) and § 1.501(c)(3)–1.

HOLDING

The hospitals in Situations 1, 2, 3, and 4 have not violated the requirements for exemption from federal income tax as organizations described in § 501(c)(3) as a result of the physician recruitment incentive agreements they have made because the transactions further charitable purposes, do not result in inurement, do not result in the hospitals serving a private rather than a public purpose, and are assumed to be lawful for purposes of this revenue ruling.

Hospital F in Situation 5 does not qualify as an organization described in § 501(c)(3) because its unlawful physician recruitment activities are inconsistent with charitable purposes.

SCOPE

This ruling addresses only issues under § 501(c)(3) in the described situations. No inference is intended as to any other issue under any other provision of law, including any issue involving worker classification, income tax consequences to the physicians, and application of the Medicare and Medicaid antikickback statute, 42 U.S.C. § 1320a– 7b(b).

DRAFTING INFORMATION

The principal author of this revenue ruling is Judith E. Kindell of the Exempt Organizations Division. For further information regarding this revenue ruling contact Judith E. Kindell on (202) 622–6494 (not a toll-free call).

Section 807.—Rules for Certain Reserves

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of May 1997. See Rev. Rul. 97–19, on this page.

Section 846.—Discounted Unpaid Losses Defined

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of May 1997. See Rev. Rul. 97–19, on this page.

Section 1274.—Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property

(Also Sections 42, 280G, 382, 412, 467, 468, 482, 483, 642, 807, 846, 1288, 7520, 7872.)

Federal rates; adjusted federal rates; adjusted federal long-term rate, and the long-term exempt rate. For purposes of sections 1274, 1288, 382, and other sections of the Code, tables set forth the rates for May 1997.

Rev. Rul. 97–19

This revenue ruling provides various prescribed rates for federal income tax purposes for May 1997 (the current month.) Table 1 contains the short-term, mid-term, and long-term applicable federal rates (AFR) for the current month for purposes of section 1274(d) of the Internal Revenue Code. Table 2 contains the short-term, mid-term, and long-term adjusted applicable federal rates (adjusted AFR) for the current month for purposes of section 1288(b). Table 3 sets forth the adjusted federal long-term rate and the long-term tax-exempt rate described in section 382(f). Table 4 contains the appropriate percentages for determining the low-income housing credit described in section 42(b)(2) for buildings placed in service during the current month. Finally, Table 5 contains the federal rate for determining the present value of an annuity, an interest for life or for a term of years, or a remainder or a reversionary interest for purposes of section 7520.

REV. RUL. 97–19 TABLE 1

Applicable Federal Rates (AFR) for May 1997

Period for Compounding

Annual Semiannual Quarterly Monthly Short-Term

AFR 6.23% 6.14% 6.09% 6.06% 110% AFR 6.86% 6.75% 6.69% 6.66% 120% AFR 7.51% 7.37% 7.30% 7.26% 130% AFR 8.14% 7.98% 7.90% 7.85%

Mid-Term

AFR 6.85% 6.74% 6.68% 6.65% 110% AFR 7.55% 7.41% 7.34% 7.30% 120% AFR 8.25% 8.09% 8.01% 7.96% 130% AFR 8.95% 8.76% 8.67% 8.60% 150% AFR 10.37% 10.11% 9.99% 9.90% 175% AFR 12.15% 11.80% 11.63% 11.52%

Long-Term

AFR 7.18% 7.06% 7.00% 6.96% 110% AFR 7.92% 7.77% 7.70% 7.65% 120% AFR 8.65% 8.47% 8.38% 8.32% 130% AFR 9.39% 9.18% 9.08% 9.01%

REV. RUL. 97–19 TABLE 2

Adjusted AFR for May 1997

Period for Compounding

Annual Semiannual Quarterly Monthly

Short-term adjusted AFR 3.97% 3.93% 3.91% 3.90%

Mid-term adjusted AFR 4.84% 4.78% 4.75% 4.73%

Long-term adjusted AFR 5.64% 5.56% 5.52% 5.50%

REV. RUL. 97–19 TABLE 3

Rates Under Section 382 for May 1997

Adjusted federal long-term rate for the current month 5.64%

Long-term tax-exempt rate for ownership changes during the current month (the highest of the adjusted federal long-term rates for the current month and the prior two months.) 5.64%

REV. RUL. 97–19 TABLE 4

Appropriate Percentages Under Section 42(b)(2) for May 1997

Appropriate percentage for the 70% present value low-income housing credit 8.65%

Appropriate percentage for the 30% present value low-income housing credit 3.71%

REV. RUL. 97–19 TABLE 5

Rate Under Section 7520 for May 1997

Applicable federal rate for determining the present value of an annuity, an interest for life or a term of years, or a remainder or reversionary interest 8.2%

Section 1288.—Treatment of Original Issue Discount on Tax-Exempt Obligations

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of May 1997. See Rev. Rul. 97–19, page 11.

Section 7520.—Valuation Tables

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of May 1997. See Rev. Rul. 97–19, page 11.

Section 7872.—Treatment of Loans With Below-Market Interest Rates

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of May 1997. See Rev. Rul. 97–19, page 11.