Blue Shield, the third-largest health insurer in California, has lost its state tax-exempt status. The California Franchise Tax Board (FTB) made the decision to revoke Blue Shield’s status in March 2015.

Blue Shield had been criticized for its higher-than-necessary reserves to pay future claims, extravagant executive pay, and purchase of a luxury box suite at Levi’s Stadium, the new home of the San Francisco 49ers in Santa Clara, California.

Given the high-profile nature of this revocation and the fact that tax-exempt status is of primary importance to not-for-profit organizations, it’s important to review the factors required for California exemption and understand what actions may put your organization at risk. We’ll discuss these below—but first, let’s begin with some background.

Background

More than 70 years ago, Blue Cross Blue Shield (BCBS) plans were organized under federal law as social welfare organizations under Internal Revenue Code (IRC) Section 501(c)(4). The plans were subsidized by members in exchange for health care benefits, and this became an integral way for their members to pay for health care. The plans are independently operated and controlled on a state-by-state basis. Various regulations control the plans in each state, and Blue Cross Blue Shield has implemented a variety of techniques to function under them.

For-profit, commercial insurers challenged the tax-exempt status of BCBS in the early 1980s, at which point the federal government created a special tax class for BCBS organizations under IRC Section 833. The California Revenue and Taxation Code didn’t conform and doesn’t offer the same reduced tax rate as the IRC. So despite the elimination of their federal tax-exempt status, many plans, like Blue Shield of California, continue to maintain their tax exemption under state and local laws.

In the 1990s, Blue Cross of California was a not-for-profit insurer, but it later converted to a for-profit company. Some of the assets held by Blue Cross of California were used to create two grant-making health foundations: California Endowment, a 501(c)(3) private foundation; and the California HealthCare Foundation, a 501(c)(4) entity. To date, many not-for-profit organizations receive grants from these foundations. At the time, creating the two new entities allowed BCBS to distribute its assets, reducing its own taxable income while also benefiting from a tax deduction for the contributions made to the newly formed exempt entities.

An Industry-Wide View

Though the rationale for a health care insurer’s tax exemption differs from that of a hospital, the bottom line is that both types of health care organizations are subject to scrutiny.

Charitable hospitals, for example, are now subject to federally mandated reporting requirements under IRC Section 501(r), which sets out four key provisions with which charitable hospitals must comply. These provisions cover financial assistance policies, billing calculations for uninsured patients, certain collection practices, and community health needs assessments to maintain their exemption. Under the final regulations, which were issued December 28, 2014, not-for-profit hospitals have been required to report statistical information related to charity care, bad-debt expenses, and unreimbursed costs for services provided through government programs.

The high-profile nature of these regulatory requirements underscores their importance: The IRS is required to report to Congress every three years on private tax-exempt, taxable, and government-owned hospitals. The IRS issued its first report of this nature on January 28, 2015, in accordance with IRC Section 9007(e)(1) as a result of the Patient Protection and Affordable Care Act.

If you think your organization may be subject to these reporting requirements, reach out to your tax advisor for help assembling the required information and updating policies to conform to final regulations.

Could Your Status Be Challenged?

FTB’s revocation of Blue Shield of California’s tax exemption requires the company to file corporate returns dating back to 2013 and could potentially cost the company tens of millions of dollars. Though Blue Shield states it still meets the requirements for state income tax exemption and has challenged the state’s ruling, the facts uncovered by FTB tell a different story.

To protect your organization from status revocation, it’s important to understand the factors that put Blue Shield at risk. Blue Shield capped its net income to 2 percent of its revenue—more than likely a product of its high expenses. Second, it ended 2014 with financial reserves of $4.2 billion. Third, the company has been criticized for extravagant executive compensation, with its former CEO earning $4.6 million. Fourth, it contributed $325 million to charitable foundations. Furthermore, the organization offers insurer rates comparable to its for-profit competitors. These factors all point toward Blue Shield functioning as a for-profit rather than not-for-profit entity.

Though the facts in Blue Shield’s case seem fairly clear, it’s still worth noting that the following will go far toward protecting your organization from a similar loss of status:

• Have a public service mission, fulfill it, and operate accordingly.
• Ensure your organization’s activities are permitted by the state section under which exemption was granted.
• If your organization is in the process of changing its activity or has changed its activity to something that may or may not be tax-exempt, consult your tax advisor.
• If your organization is exempt under state and local laws but doesn’t qualify for exemption from federal income tax, consult your tax advisor—this could signal a vulnerability.

Also worth noting are the penalties and interest your organization could be subject to if its status is revoked; these vary by state. In California, entities that have their status revoked will be subject to a tax rate of 8.84 percent and a California interest rate of approximately 3 to 4 percent. If it’s determined that there were filing errors on previously filed returns, the state can also impose an accuracy-related penalty and a penalty for failure to pay tax by its due date.

Be Proactive

If you’re concerned that your organization’s status may be in danger, address those concerns now. To learn more about how you can protect your organization’s tax-exempt status or what factors might put you at risk of losing your California tax exemption, contact your Moss Adams not-for-profit professional.