The prospect of being able to offer a 403(b) tax-deferred retirement plan to employees is probably the chief incentive for district hospitals to seek 501(c)(3) status. Thus, a significant number of Washington district hospitals have adopted, or have contemplated adopting, a strategy which would allow them to offer a Section 403(b) retirement plan, rather than the Section 457 plan available to municipal corporations and public employees. This strategy consists of qualifying for 501(c)(3) tax exempt status.

Historically, a Section 457 retirement plan suffered in comparison to both its 401(k) and 403(b) counterparts. First, the Section 457 rules cap the amount of nonqualified deferred compensation that can be accrued without current tax for employees. The maximum excludable benefit is the lesser of $8,000 per year, or one third of the employee's includable compensation, with a higher ceiling for employees nearing retirement. In contrast, a Section 403(b) plan is subject to a $10,000 annual limit on contributions. Moreover, Section 403(b) rules provide for cost of living increases to that annual limit. Next, the accrued benefits under a Section 457 plan, until paid to the employee, were the property of the employer and to the claims of the its general creditors. While the risk of loss to hospital district employees by claims of creditors under a 457 plan might, in most practical cases, be remote, such risk is nonexistent under the structure of a 403(b) plan.

Recent (August, 1996) changes to Section 457 under the Small Business Protection Act (H.R. 3448) have eliminated most of the important differences between the rules for Section 457 plans and Section 403(b) plans. Now, accrued benefits in a Section 457 plan must be held in trust for employees, and are thus protected from the demands of their employer's creditors. Moreover, while the limit on total annual contributions to a 457 plan has not been raised, the new law provides for periodic (and retroactive) COLA increases to the dollar limit on deferrals.

There are other benefits that may flow from obtaining 501(c)(3) status. (These advantages are also available to municipal corporations which are not tax exempt charities). Such benefits might include:

Members of the local community (businesses as well as residents) are in general favorably disposed toward organizations that are designated as "charitable." Designation as a 501(c)(3) charity could enhance an organization's image in the community at large.

Donors may prefer to make gifts and/or bequests to 501(c)(3) entities over other types of organizations because more of their gift will thus qualify for deduction. In fact, a potential donor may condition such a gift upon the existence of the donee's 501(c)(3) status.

In terms of clarity of charitable purpose, a 501(c)(3) hospital may have some slight public relations advantage in that its characteristics and charitable purpose may be more readily understood by community members and outsiders than that of a "municipal corporation." Documentation of 501(c)(3) status, in the form of a standard determination letter from the IRS, is clear and explicit. Conversely, documentation which describes or affirms a hospital district's creation or powers may be much less informative to constituents and other interested parties.

In summary, there are some important restrictions and requirements that accompany qualification for 501(c)(3) status that hospital districts must understand in order to be in compliance with federal regulations. Several of these requirements will be discussed in the following subsections of this document.

In order to begin to understand the differences between the law governing tax exempt charities versus public hospital districts, one must be aware of the means by which an organization qualifies for 501(c)(3) status. An organization seeking to qualify under IRC Section 501(c)(3) must be owned and operated for an exempt purpose; in the case of a public hospital district, the charitable activity of providing healthcare services for the benefit of the community supplies this exempt purpose. Section 501 of the IRC defines a qualifying organization as one which:

• Permits no part of net earnings to inure to the benefit of any private shareholder or individual;

• Directs no substantial part of its activities toward carrying on propaganda, or otherwise attempting to influence legislation, except as provided under 501(h); and

• Does not participate in or intervene in (including publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for political office.

In order to qualify for (c)(3) status, a hospital district must also meet the criteria for two tests applied by the IRS: the organizational and operational tests.

The requirements of the organizational test explicitly restrict the purpose and goals of the hospital district to those relating to providing healthcare services to the community (the "exempt purpose"). The bylaws and/or charter of an organization seeking qualification cannot be written so as to empower it to act beyond its exempt purpose. In addition, such an organization must clearly and permanently dedicate its assets to achievement of its exempt purpose. Treas. Reg. 1.501 (c)(3)-1(b). In the case of a hospital district, a board resolution should be submitted to the IRS which formally adopts the 501(c)(3) definition of a qualifying organization, thus restricting the organization's purpose and activities to those permitted under the 501(c)(3) rules. Specifically, the exempt organization must comply with limitations imposed with respect to dissolution, inurement (self-dealing), and political activity.

Practical Consideration

The IRS will examine an organization's "creating document" when it applies the organizational test. Therefore, a public hospital district should also include in its submission to the IRS a copy of RCW 70.44 ; the narrow statutory scope of hospital district functions and power set forth by RCW 70.44 is accepted by the IRS as evidence that the hospital district meets the organizational test.

The IRS requires that in the event of dissolution, an exempt organization's assets remaining at time of dissolution (after payment of debts and liabilities) must be distributed to:

• A nonprofit organization created to succeed the dissolved hospital district, as long as the new entity is either a governmental unit as provided under IRC Section 170(c), or a 501(c)(3); or

• A separate nonprofit with similar aims and objectives as long as it is either a Section 170(c) or Section 501(c)(3) entity.

RCW 53.48 (Dissolution of Port and Other Districts) provides that after dissolution of a municipal corporation, its remaining assets may be distributed to a school district, which qualifies as a Section 170(c) governmental unit. The documents submitted to the IRS by the hospital district should include a copy of this statute.

The rules governing 501(c)(3) exempt organizations forbid private inurement; that is, for a hospital district, the distribution of net earnings to commissioners, directors or any private individuals. In contrast, such distributions by a hospital district may be, (but not necessarily are) prohibited under the Washington State Constitution as gifts of public funds. The IRS also requires that an organization attempting to qualify for (c)(3) status provide documentation of its exempt purpose. RCW 70.44.003 specifically authorizes and limits a hospital district to operate for the charitable purpose of providing healthcare.

In addition to the above, the hospital district bylaws must specifically prohibit "political activities," which are defined by the IRS as "an action involving election or appointment of someone to office, or intervention in the electoral process." Treas. Reg. 1.501 (c)(3)-1(b)(3) and (c)(3)(iii). In contrast to "political activity", some degree of lobbying by a 501(c)(3) organization is permitted. The IRS considers lobbying to be "legislative action," which is activity directed toward influencing persons after they have been elected or appointed.

While the organizational test is imposed to limit the power of a tax-exempt entity to engage in activities beyond its exempt purpose, the operational test monitors the organizations actual behavior.

A 501(c)(3) entity must operate "exclusively" for a charitable purpose, although it is worth noting that "exclusively" does not mean "100%." The characteristics of exclusive operation include:

• Operating for the benefits of an indefinite class of persons rather than for an individual or limited group; and

• Excess revenue accumulation ("profit") must be amassed for the purpose of advancing the interests of the exempt organization over time, i.e., working capital to assure continued operations and to maintain/expand physical facilities; or, to establish or expand programs for hospital district constituents.