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Fair Market Value in Health Care Transactions 

by Lewis Lefko

Published: July, 2007

Submission: September, 2007


This paper will address the varying requirements for fair market value in transactions involving physicians and hospitals and other health care providers. The paper will first examine the Stark law and how and when transactions may satisfy Stark’s requirements for fair market value. Second, the use of fair market value for compliance with the federal Anti-Kickback statute will be addressed. The paper will then address the implications of fair market value for transactions between physicians and tax exempt hospitals and health care providers and the possible implication of IRS intermediate sanctions. Fourth, the paper will examine legal issues arising from valuation of health care transactions. Finally, this paper will address practical considerations to consider when relying on fair market value as a means of federal fraud and abuse law compliance efforts.

Defining Fair Market Value, Commercial Reasonableness and Reasonable Compensation.

A. Fair Market Value. Fair market value is a business valuation concept that has significant implications for transactions involving health care providers. The definition of fair market value for general business valuation purposes is considered the price at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms-length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.1 Nearly every health care business transaction must be based on some measure of fair market value. Setting a transaction at fair market value attempts to ensure the price paid will be comparable to that which would typically be paid by unaffiliated third parties. The need to set a health care transaction at fair market value can come from a number of sources. Fair market value can be defined and measured in a number of ways. Federal fraud and abuse laws, such as the Stark law and Anti-Kickback statute, generally require contract terms to be set at fair market value if referrals occur between the contracting parties for services reimbursed by federal health care programs. Fair market value issues also arise in transactions involving tax exempt entities.

B. Commercial Reasonableness. Determining what is commercially reasonable is a separate inquiry beyond fair market value and generally only applies specifically to federal fraud and abuse laws. In theory, most business transactions must be commercially reasonable or there would be no reason for them to occur. For health care transactions, what is commercially reasonable requires a unique inquiry. Essentially, whether a transaction is commercially reasonable requires a look into the underlying economics of a transaction for the parties involved without taking into account the potential for referrals between the parties to the deal. The Stark Phase II commentary suggests “[a]n arrangement will be considered ‘‘commercially reasonable’’ in the absence of referrals if the arrangement would make commercial sense if entered into by a reasonable entity of similar type and size and a reasonable physician (or family member or group practice) of similar scope and specialty, even if there were no potential DHS referrals.”2 As a whole, commercial reasonableness is a separate and distinct process from determining whether a transaction is established at fair market value.

C. Reasonable Compensation. Another issue that relates closely to fair market value in a compensation arrangement is whether the amount is “reasonable.” Any type of compensation paid to physicians must be “reasonable” to qualify for deduction and to avoid penalties and sanctions for exempt entities under IRS rules. The IRS generally defines “reasonable compensation” as the amount that would ordinarily be paid for like services by like organizations in like circumstances.3

III. Stark Law.

A. The Stark Law. The Stark Law prevents an entity from billing Medicare or Medicaid for designated health services (“DHS”) referred by a physician with which the entity has a financial relationship unless the relationship fits within an exception.4 A wide range of services are considered DHS including all inpatient and outpatient hospital services.5 Financial relationships include both ownership interests and compensation arrangements.6

B. Stark Law Definition of Fair Market Value. The Stark law generally requires remuneration to be set at fair market value and not determined in a way that takes into account the volume or value of referrals to the entity. The Stark statute defines “fair market value” as the value in arms-length transactions, consistent with the general market value.7 “General market value” is defined by the Stark regulations as the “price that an asset would bring as the result of bona fide bargaining between well-informed buyers and sellers who are not otherwise in a position to generate business for the other party, or the compensation that would be included in a service agreement as the result of bona fide bargaining between well-informed parties to the agreement who are not otherwise in a position to generate business for the other party, on the date of acquisition of the asset or at the time of the service agreement.”8

            The Stark regulations generally define “fair market price” as:

“the price at which bona fide sales have been consummated for assets of like type, quality, and quantity in a particular market at the time of acquisition, or the compensation that has been included in bona fide service agreements with comparable terms at the time of the agreement, where the price or compensation has not been determined in any manner that takes into account the volume or value of anticipated or actual referrals.” 9

C. Application to Stark.
i. Fair Market Value and Compensation Arrangements. Compensation arrangements with physicians may arise in a wide range of situations. If a compensation arrangement can be identified, advance planning may allow for the use of a Stark exception to avoid noncompliance with the Stark law. Most Stark exceptions that are available for compensation arrangements set forth fair market value as one of the conditions that must be met, such as the office space, equipment rental, personal service arrangements, employment, payments by physician, and fair market value compensation exceptions.10

ii. Fair Market Value for Purposes of the Rental of Office Space and Equipment Rental Exceptions. Fair market value for purposes of the rental of office space and equipment rental exceptions means “means the value of rental property for general commercial purposes (not taking into account its intended use):”11

In the case of a lease of space, this value may not be adjusted to reflect the additional value the prospective lessee or lessor would attribute to the proximity or convenience to the lessor when the lessor is a potential source of patient referrals to the lessee. For purposes of this definition, a rental payment does not take into account intended use if it takes into account costs incurred by the lessor in developing or upgrading the property or maintaining the property or its improvements.12

iii. Physician Compensation. To determine if a physician compensation arrangement meets Stark’s requirements, the Center’s for Medicare and Medicaid Services (“CMS”) has provided two methods that ensure an hourly compensation arrangement agreement for a physician’s personal services, such as a medical director arrangement, fit within Stark exceptions.

The Stark Phase II preamble specifically provides that two measures of hourly physician compensation if followed will be deemed to occur at fair market value. Under the first method, the hourly rate paid to a physician must be less than or equal to the average hourly rate for emergency room physician services in the relevant physician market.13 In order to have a suitable physician market, at least three hospitals must be providing emergency room services in the market.14 The second method requires the hourly rate to be calculated by averaging the national compensation level for physicians with the same physician specialty listed in at least four of six designated surveys and dividing by 2,000 hours.15 If neither of these methods is available, the approximate method of valuation will depend on the nature of the transaction, its location and other factors.

On-Call Compensation. Hospitals increasingly are required to provide physicians with compensation for being on-call to hospital emergency departments. The precise manner in how to establish fair market value for these arrangements is not specifically addressed by the Stark regulations because the nature of these agreements do not fit within a traditional employment role. Generally, the initial task in determining on-call pay to a physician is to determine what is actually required of an on-call physician. If an on-call physician must be on-site at the hospital, on-call payments should generally be greater than if a physician is permitted be off-site while on-call.

There are several ways to document fair market value for on-call arrangements. One method is to base a physician’s on-call pay on that of other physicians of the same specialty in the geographic market. Another method requires a hospital to develop its own payment based on physician salary information and past experience with on-call requirements for a particular specialty. This method may be necessary if no on-call data is available for the particular specialty in the market. The hospital should be able to determine the ratio of the on-call physician hourly payment to an employed physician’s hourly rate. Using this ratio for determining on-call rates for other specialties may approximate fair market value. Differences in individual markets may exist and require adjustments. Tracking actual past on-call experience should also assist in setting future on-call physician payments.

iv. Regulatory Guidance on the Application of Fair Market Value for Stark Exceptions. The Stark regulations and commentary provide insight into how CMS expects the fair market value requirements of Stark exceptions to be applied in transactions. The Stark Phase One commentary suggests a wide range of methods may be acceptable to determine fair market value.16 CMS indicates they will accept any method that is commercially reasonable and provides evidence of how the compensation paid is comparable to what is ordinarily paid for the item or service by parties in an arms-length transaction at the particular location.17 As for the use of comparables that involve physicians in a position to refer, CMS cautions that any comparison that may take into account the volume or value of referrals between physicians and an entity will not serve as a permissible comparison.18 CMS indicates it will accept a list of comparable leases for purposes of the office space exception and independent appraisals may also provide evidence of fair market value. Cost plus a reasonable rate of return may also be an acceptable methodology.

An independent valuation expert should be consulted to assist in determining fair market value if other appraisals are not available from a third party source. Although CMS indicates that independent valuation experts are not required for an accurate, reliable and valid appraisal, the effect of using an expert cannot be ignored. 19 CMS suggests that internally-developed valuation methods are susceptible to manipulation and may be subject to more intensive scrutiny than an independent survey.20

v. Case Law on Fair Market Value under Stark. As the Stark concept of fair market value is relatively new, it has not had much case law in terms of enforcement history.21 A significant case that has addressed the definition and determination of fair market value is Goodstein v. McLaren.

1. Goodstein v. McLaren. 22 The case involved a qui tam action in which the court looked at the determination of fair market value for purposes of the Stark office space exception and the Anti-Kickback statute for an office lease by physician lessors to a hospital.23 The parties agreed to limit the issue before the court to whether the office lease occurred at fair market value.24 After hearing from experts from both sides, the court determined the lease had occurred at fair market value and the case was dismissed.25 McLaren provides an example of how a court may interpret fair market value for purposes of Stark.

McLaren combined the Stark and Anti-Kickback exception and safe harbor and the case was decided by a battle of the expert witnesses. The evidence of an intense, protracted price negotiation and the hospital’s securing advantageous lease terms convinced the court that an arms-length transaction had occurred. The defendants’ experts presented a strong enough case to defeat the government experts' determinations of fair market value. The court was particularly critical of the government experts’ reports that: a) failed to consider relevant lease terms; b) used a too restrictive market area for comparison; and c) lacked comparable buildings in the analysis.

2. U. S. v. Aging Care Home Health.26 A home health agency was found to have violated the Stark Law with respect to its medical director contracts. In ordering restitution of $400,000 to the Medicare program for amounts the agency had claimed on cost reports, the Court held that Stark II was self-executing on January 1, 1995, its effective date. The Court cited the agency’s failure to comply with the personal services arrangements exception, particularly payments in excess of fair market value.

3. Renal Physicians Association v. HHS.27 The Renal Physicians Association challenged the fair market value criterion in the Stark Law arguing that facilities which used the valuation methods deemed as fair market hourly rate compensation would limit the incomes of their physician members. The Court ruled that the methods were merely an available option for calculating fair market value compensation. If physicians’ hourly rates declined, the Court ruled it was not due to the fair market value criterion but the independent actions of dialysis facilities and hospitals to reduce medical director compensation to the levels deemed fair market value. The Court noted that even if the voluntary fair market value methods were declared invalid, the facilities that intend to comply with Stark would likely continue to rely on the methods as proof of fair market value, knowing with some assurance that CMS will likely accept this proof as indicative of fair market value.

The significance of fair market value and commercial reasonableness to medical director agreements may be found in the report of the government’s expert in U.S. v. SCCI Hospital Houston.

4. U.S. v. SCCI Hospital Houston. This qui tam case (settled by the parties) involved the issues of fair market value and commercial reasonableness of the compensation paid by SCCI Hospital-Houston to three physician medical directors.28 The U.S. brought the action under the False Claims Act and under theories of fraud, unjust enrichment, payment by mistake of fact, recoupment and disgorgement of illegal profits. Alleging that the Hospital and three physicians submitted or caused the submission of false and fraudulent claims, false statements and cost reports in order to obtain Medicare program payments, the government described the false claims, false statements and cost reports as an unlawful scheme by the Hospital to obtain business by paying illegal remuneration and entering into prohibited financial relationships with the physicians in violation of Stark. Such claims and cost reports were false and/or fraudulent under the False Claims Act because the Hospital and physician had no entitlement to payment for services provided on referrals from physicians who had illegal financial relationships with the Hospital.

The scheme allegedly was an attempt to disguise illegal payments with sham medical directorships. Under Stark, compensation paid to a physician under a medical directorship that exceeds fair market value, or for which no actual services are rendered, triggers the referral and payment prohibitions of Stark with respect to inpatient and outpatient hospital services referred by such physician. According to the government, the medical director agreements required duties to be performed, but payment was made to the medical directors regardless of what duties were performed, and even when no duties were performed. The three physicians performed little or no work in their capacity as medical directors, and generally failed to document the few services they did provide.

The Hospital’s medical directors were the primary source of patient referrals to the Hospital. During the 1997-1999 period, the Hospital had ten medical director contracts which they reduced to the contracts with the three physicians upon receiving a copy of the relators’ original complaint. The Hospital routinely tracked and assessed the number of referrals by each physician. The activity/time reporting form for medical directors asked the physician to report his referrals for the reported month.

The federal government’s expert filed a report addressing the issues of fair market value, commercial reasonableness and reasonable compensation with respect to the medical director agreements.29 The fair market value definition used by the expert was the standard “willing buyer/willing seller” definition as well as the Stark definition of fair market value.

The expert’s reasoning on fair market value assumed the medical director services were valued on the basis of time spent performing duties multiplied by a commercially reasonable hourly rate of pay. The expert noted hospitals use time records that report time spent on medical director functions, or evaluate time expended by reviewing a medical director’s work product and other evidence of performance such as committee meeting minutes, teaching and training materials, institutional planning reports, recommendations made, professional reports and presentations developed. According to the expert, hourly pay rates are best determined by comparing rates paid in similar situations or by using compensation rates from available industry data.

The government’s expert opined that the medical director fees did not reflect fair market value. There was no evidence of independent fair market valuations, no documentation of efforts to search the Houston market for amounts paid in comparable agreements and circumstances, and the hourly rates of pay were routinely higher than industry norms. There were material inconsistencies in the hourly rates paid to the three directors even though all three practiced internal medicine.

The expert questioned the validity of the time reporting as the inspection revealed inaccuracies, unusual patterns and suspicious issues. For example, the physicians were tardy in recording their time as some reports were dated three to four months after the month reported. The expert challenged whether the physicians could recall activities performed after such a time lapse. A pattern involving the reporting of the same number of hours for the same activity was evident over a period of 14 months for one physician. Agendas, sign-in sheets and meeting minutes did not correspond to the medical directors’ time sheets. The Hospital did not issue any instruction to the physicians on how to distinguish activities and allocate time between the distinct functions of patient care and administrative duties performed for the Hospital as a medical director. Medicare does not allow physicians to report patient care as an administrative duty as such a practice would result in double payment to the physician who is already paid for patient care under Medicare Part B.

According to the expert, commercial reasonableness of a medical director depended on the agreement being essential to the functioning of the hospital, i.e., there had to be sound business reasons for paying medical director fees to referring physicians. The expert looked for justification of the need for medical director services by considering:

• The size of the hospital, number of patients, patient acuity levels and patient needs;

• The quality, activities and involvement of the medical staff and the need for medical direction;

• The number of regular committees and meetings that require physician involvement; and

• The quality of hospital management and interdisciplinary coordination of patient services.

According to the government’s expert, commercial reasonableness also depends on the hospital performing a regular assessment of the actual duties performed by the medical directors. The assessment should clearly show how effectively the medical director is performing his duties and whether there is a bona fide need for continuing the services. The expert stated responsibilities that were part of a physician’s duties as a treating physician or required responsibilities of all physicians outlined in the hospital’s medical staff bylaws were not commercially reasonable duties for a paid medical directorship.

The expert determined that the medical director fees were not commercially reasonable. Due to the Hospital having a small size (32 beds) and relatively low patient census (18-23 patients), contracting with more than four medical directors was determined to be excessive as patient care concerns could be managed with fewer directors. A comparison of duties and responsibilities in the medical director agreements and medical staff bylaws revealed similar responsibilities for which directors should not be paid. The expert determined that only one medical director needed to attend the regular meetings held by the Hospital’s management, and that medical directors should not be paid to attend and participate in medical staff committee meetings since all physicians were required by the medical staff bylaws to attend such meetings on a regular basis. Since the Hospital was part of a chain of long term acute care hospitals, the expert determined fewer medical directors were needed as excellent patient protocols and interdisciplinary coordination mechanisms were already in place. The expert did not find evidence of regular Hospital management oversight or assessments of each medical director’s performance, and Hospital management did not react when medical directors were non-compliant.

IV. Anti-Kickback.

A. The Anti-Kickback Statute. The Anti-Kickback Statute provides that anyone who knowingly and willfully solicits or receives any remuneration in return for referring an individual to a person for the furnishing of any item or service for which payment may be made under a federal health care program is prohibited.30 Anti-Kickback covers payment of anything in value (including providing items or services for free) in exchange for referrals, as well as the offer or payment of anything of value in return for purchasing, leasing, ordering or arranging for or recommending the purchase, lease or ordering of any item or service reimbursable by a federal health care program. The Anti-Kickback Statute is broader than the Stark law because it covers all health care services reimbursed by a federal health care program and not just designated health services. But, it is narrower in application because Anti-Kickback requires showing the conduct in question was performed with intent rather than the strict liability applying to arrangements under Stark.31 Anti-Stark extends equally to the solicitation or acceptance of remuneration for referrals or other business.

The Office of Inspector General (“OIG”) of the U.S. Department of Health and Human Services and the courts have generally followed a test that if one purpose of a payment is to induce or reward referrals to a health care provider, Anti-Kickback has been violated.32 Other courts have established a greater standard of proof involving a showing of intent and a willful violation of Anti-Kickback.33

In early fraud alerts34, the OIG opined that whenever a health care provider offers or gives to a source of referrals anything of value, or a referral source solicits or receives anything of value from the provider, that is not paid at fair market value, an inference may be made that the thing of value is offered to induce or reward the referral of business. For the OIG, “fair market value” meant value for commercial purposes that reflected an arm’s-length transaction which had not been adjusted to include the additional value which the provider or referral source had attributed to the referral of business between them.

Recently, the OIG has expanded on its view of fair market value in compliance guidance to hospitals on compensation arrangements with physicians:

The general rule of thumb is that any remuneration flowing between hospitals and physicians should be at fair market value for actual and necessary items furnished or services rendered based upon an arm’s-length transaction and should not take into account, directly or indirectly, the value or volume of any past or future referrals or other business generated between the parties.

Arrangements under which hospitals (i) provide physicians with items or services for free or less than fair market value, (ii) relieve physicians of financial obligations they would otherwise incur, or (iii) inflate compensation paid to physicians for items or services pose significant risk.

In such circumstances, an inference arises that the remuneration may be in exchange for generating business. 35

However, the OIG interprets Anti-Kickback to mean that neither a legitimate purpose for the business arrangement nor a fair market value payment will legitimize a payment if the illegal purpose of inducing or rewarding referrals is present.

B. Fair Market Value in the Safe Harbors.

The Anti-Kickback Statute and the OIG’s regulations have established a number of “safe harbors” for common business arrangements. Safe harbor compliance requires strict compliance with the conditions set forth in the safe harbor. Safe harbors requiring that payments be at fair market value include those for space rentals, equipment rentals, personal services and management contracts, and ambulance replenishing.

For the space and equipment lease safe harbors, fair market value rentals are those that are not adjusted to reflect the additional value the lessor or lessee would attribute to the property as a result of its proximity or convenience to sources of referrals.36 Space lease rentals must be based on the value of the property for general commercial purposes.37 Equipment lease rentals must be based on the value of the equipment when obtained from a manufacturer or professional distributor.38 For leases the OIG additionally advises using independent fair market valuation with appropriate health care valuation standards.39

Though the personal services and management contracts safe harbor does not provide a definition of fair market value, the OIG cautions hospitals to consider the risk of fraud and abuse in these factors relating to fair market value of compensation:40

• Fair market value in an arm’s-length transaction;

• Availability of the services from a non-referral source at a cheaper rate or under more favorable terms;

• No taking into account, directly or indirectly, the value or volume of any past or future referrals or other business generated by the parties;

• No direct or indirect ties between compensation and Federal health care program reimbursement;

• Use of a reasonable compensation methodology that is uniformly applied and properly documented;

• If compensation is based on comparables, assurance that the market rate is not distorted (e.g., if all providers of the purchased service in the relevant market are controlled by physicians); and

• Compensation for a physician commensurate with the skill level and experience reasonably necessary to perform the contracted service.

C. OIG Advisory Opinions.

The OIG offers advisory opinions to requestors about their particular business arrangements. The advisory opinions are binding on the requestor regarding whether the arrangement violates Anti-Kickback or other OIG fraud and abuse authorities. The OIG is prohibited from addressing whether fair market value will be or was paid or received for any goods, property or services. However, the OIG does deal broadly with issues of value in advisory opinions as indicated in these examples:

99-2 – The OIG views as suspect discounts below fully loaded costs, and discounts less than prices given to others with similar volumes but no potential for referrals.

03-8 – The OIG noted that “per patient”, “per order”, “per click” and similar payment arrangements with referral sources are disfavored. The principal concern is that such arrangements promote overutilization.

04-08 – The OIG had significant concerns with respect to fair market value of an arrangement involving multiple, overlapping, part-time leases of shared physical therapy services where the rental was an equal, fixed monthly rental amount. The OIG noted the structure increased the risk that the sharing physicians will pay more or less than fair market value for the space, equipment and administrative services actually used. Overlapping, as-needed leases would make it difficult to monitor, assess and document market value.

06-02 – The OIG noted that percentage-based compensation was inherently problematic from a fair market value perspective because the compensation necessarily relates to the volume and value of business generated between the parties.

V. Tax Exemption

A. Tax Exempt Organization Considerations. A tax exempt organization must not be organized or operated for the benefit of private interests. No part of the net earnings of an exempt organization may inure to the benefit of any individual. Payments in excess of fair market value may result in Internal Revenue Services (“IRS”) determinations that inurement or impermissible private benefit occurred. Failure to establish fair market value may result in loss of exemption, payment of taxes, loss of tax-exempt status for bonds and/or intermediate sanctions.

B. Intermediate Sanctions Law. The Intermediate Sanctions Law imposes sanctions on disqualified persons within charitable or social welfare organizations who receive excessive economic benefits from the organization.41 Disqualified persons are individuals who are in a position to exercise substantial influence over the tax-exempt organization, including officers and directors. With respect to exempt health care organizations, physicians may be disqualified persons if they exert substantial influence or control due to their positions within the medical staff, medical directorships or other arrangement. Intermediate sanctions include both excise taxes on the excess benefit and correction of the excess benefit transaction by those disqualified persons who engaged in the transaction.

An excess benefit may arise in an exchange of compensation or benefits in return for the disqualified person’s services, or in a property exchange between the disqualified person and the organization. The excess benefit occurs if the value of the economic benefit paid or provided by the organization exceeds the value of the services performed by the disqualified person who received the economic benefit. Fair market value is the standard for the determination of value.

To avoid legal problems under the Intermediate Sanctions Law, the exempt organization should establish a rebuttable presumption of reasonableness with respect to the transaction through the following procedures:

• Identify all disqualified persons within the organization;

• Identify all transactions with disqualified persons before they are approved;

• Obtain objective, third party written evidence, e.g., surveys or studies, that the consideration in the transaction is fair market value through comparability data in a valuation or fairness opinion;

• Present the transaction and the comparability data to the members of organization’s board of directors who do not have any personal interest in the arrangement, or an authorized board committee, for its consideration and approval;

• Obtain an express finding from the disinterested members of the board or its authorized committee that the comparability data were relied on in finding the transaction to be in the best interest of the organization and the public it serves;

• Reflect the preceding process and document the basis for the determination concurrently with the approval in the board’s or committee’s minutes and the intention of the board or committee to establish a rebuttable presumption of reasonableness; 

• Have the board or committee approve the documentation at its next meeting; and

• Retain the comparability data and other documentation of the decision in the board’s or committee’s files.

The fair market value standard for an exempt organization is the price a willing buyer would pay a willing seller for property, or the right to use property, neither being under any compulsion to buy, sell, transfer or use the property, and both having reasonable knowledge of all relevant facts. With respect to the performance of services, the fair market value for the services is reasonable compensation, which is the value ordinarily paid for similar services by a similar organization under similar circumstances.

If the above procedures are followed, the provider is entitled to a rebuttable presumption that the compensation is reasonable compensation. The presumption may only be rebutted by sufficient contrary evidence to rebut the probative value of the provider’s supporting compensation data.

C. Transactions with Tax Exempt Entities. Transactions between exempt health care organizations and physicians must be accomplished so there is no excessive private benefit conferred on the physician. The fair market value related to the transaction must be documented in order to establish that any private benefit is merely incidental. The IRS has issued guidance on how hospitals and other health care providers may conduct certain transactions with physicians:

i. Office Space.42 IRS Revenue Rulings have approved hospitals leasing space to physicians at locations adjacent to the hospital campuses furthering the hospital’s exempt purpose by facilitating patient access to the hospital. The office rental must be fair market value and the hospital must explain how it established a commercially reasonable lease.

ii. Equipment Lease.43 Equipment leased by an exempt healthcare provider from a medical staff member must be the result of an arms-length negotiation, represent fair market value, and be commercially reasonable. If the lease payment is significant, the IRS recommends an independent valuation be obtained.

iii. Purchase of Physician Practices.44 When a hospital purchases a physician’s practice, the hospital should be prepared to justify the terms of the purchase through a timely valuation of the assets to ensure the hospital will not overpay. Such an appraisal should uses costs, market and/or income valuation method, or a combination thereof, to arrive at fair market value. A written purchase and sale contract should be developed that includes any retained rights by the physician to affect future affiliations with other physicians, to determine if additional physicians can be hired, or to repurchase the assets within a certain time period.

iv. Incentive Compensation.45 Any compensation between an exempt health care provider and an employed or independent contractor physician must not result in private inurement for the physician, and must not confer impermissible private benefit. The implicit requirement is that any compensation paid must be reasonable compensation. Healthcare organizations may use physician incentive compensation arrangements to accomplish goals of quality, efficiency, productivity, patient satisfaction, and reduction of cost by structuring the physician incentive compensation arrangement with consideration to the follow-ing factors:

• Review and approval by an independent board of directors acting pursuant to a conflicts of interest policy barring physicians who are board members from participating/voting on their own compensation and restricting physicians from membership on the board’s compensation committee;

• Determination that total compensation paid to the physician is reasonable compensation;

• Negotiation through an arms-length relationship so that the compensation arrangement is not affected by the physician’s participation in the management or control of the provider;

• Inclusion of a ceiling or reasonable maximum on the amount a physician may earn to protect against projection errors or windfall benefits;

• No potential for payment of the incentive compensation to reduce the charitable services or benefits the provider would otherwise provide;

• Takes into account data measuring quality of care and patient satisfaction;

• Accomplishment of the provider’s charitable purposes, including keeping expenses within budget where expenses determine charges, if the physician’s compensation is net revenue-based;

• No transformation of the provider’s principal activity into a joint venture between it and the physician;

• No use of the physician incentive compensation as a device to distribute all or a portion of the provider’s profits to the physician or others in control of the provider;

• Relationship to a real and discernible business purpose of the provider, such as achievement of maximum efficiency and economy independent of any purpose to operate the provider for the impermissible direct or indirect benefit of the physician;

• Effective controls to guard against increases in patient fees or unnecessary utilization and other measures to prevent abuse or unwarranted benefits; and

• Reward of the physician based on services actually performed.

D. Case Law on Fair Market Value Related to Tax Exempt Entities.

Caracci v. Commissioner of Internal Revenue Service.46 This case involved an action against the Caracci family and the non-profit Sta-Home Health agencies controlled and operated by the Caracci family for alleged excess benefit transaction-related tax deficiencies resulting from the conversion of the Sta-Home to for profit status. Relying on two separate appraisals of Sta-Home, the Caracci’s assumed the consideration for the conversion (assumption of Sta- Home’s debts and liabilities) exceeded the fair market value of Sta-Home’s assets due to an ongoing lack of profits and capital deficit, therefore leaving Sta-Home with no real value. The IRS assessed the Caracci family $260 million in excise taxes and penalties on its belief that Sta-Home’s assets were more valuable than the assumption of liabilities.

The Fifth Circuit Court of Appeals examined the reasons why the Caracci family expert chose an income approach to valuing Sta-Home rather than a market approach using comparable sales or transfers of similar home health agencies. The Fifth Circuit, in agreeing with the Caracci’s expert, stated many corporate aspects of the subject corporation and the corporations to which it will be compared must be comparable including, public/private status, capital, profitability, product/service limitations and revenue sources. If a market approach is used, the fair market valuation must take into account all possible comparable aspects of a company that could have an affect on the valuation. The court agreed such comparable did not exist with respect to Sta-Home. The Court noted that Sta-Home’s intangible assets did not contribute to fair market value unless those assets produce net income or earnings. The Fifth Circuit stressed the necessity for valuations to take into consideration as many details as possible. In the absence of an appropriate comparable market, each of the Sta-Home’s assets must be valued and weighed against liabilities and debts in order to obtain fair market value.


VI. Legal Issues in Valuation Approaches. Valuation consultants and attorneys often struggle with the relationship between valuation models applied to a health care entity or transaction and the referral and payment prohibitions of Stark and Anti-Kickback. The OIG summed up the problem in a 1992 letter to the IRS:

 “When considering the question of fair market value, we would note that the traditional or common methods of economic valuation do not comport with the proscriptions of the Anti-Kickback statute. Items ordinarily considered in determining the fair market value may be expressly barred by the Anti-Kickback statute’s prohibition against payments for referrals. Merely because another buyer may be willing to pay a particular price is not sufficient to render the price to be paid fair market value. The fact that a buyer in a position to benefit from referrals is willing to pay a particular price may only be a reflection of the value of the referral stream that is likely to result from the purchase.”47

Similarly, the definition of “fair market value” in Stark is qualified in ways that do not necessarily comport with use of the term in standard valuation methods. Stark specifies that the valuation method must exclude valuations where the parties to the transaction are at arm’s-length but in a position to refer to each other.48

Problem areas in valuations for health care provider and physician arrangements and transactions which raise questions on fair market value include:

A. Leases.

• Whether value attached by either party was based on proximity or convenience?

• Whether the cost of developing, upgrading or improving the property were considered?

• Whether prorations of common space were included?

• Whether rent is commercially reasonable even if no referrals were made between the parties?

B. Compensation Arrangements.

• Whether comparable services would cost as much if acquired from a non-referral source?

• Whether the compensation is a disguised distribution of profits?

• Whether the compensation is the result of arm’s-length negotiation?

• Whether specialty, age, skill level, productivity, and experience were considered?

• Whether comparable compensation arrangements are distorted due to market characteristics or tainted due to taking into account the value or volume of referrals?

C. Physician Practice Purchases.

• Whether payments for goodwill, value of ongoing business unit, covenants not to compete, exclusive dealing arrangements, patient lists and patient records are for the value of the referrals from the selling physician?

• Whether the economic position of the selling physician is expected to significantly improve as a result of the acquisition?

• Whether referral patterns before and after the acquisition changed to favor the acquiring health care provider?

• Whether the valuation overstates the value of the practice by underestimating the risks of future cash flows?

• Whether the value has been overestimated by improper or unrealistic assumptions as to future growth in cash flows or profits?

• Whether increased utilization and intensity of service assumptions are balanced by expense and capital outlay requirements and an evaluation of properly documented and clinically appropriate coding practices?

• Whether comparability of transactions addressed markets served, practice and specialty type, competitive positions, profitability, growth prospects, risk perceptions, capital structure, physician compensation, physician age, health and reputation, productivity, average revenues per physician, cost structure, average revenue per visit and payor mix?

D. Best Practices for Valuations.

• Valuations need time for a reasonable and proper process to occur.

• The appraiser must be well-qualified and able to testify as an expert witness.

• The valuation must rely on appropriate data for comparability including independent surveys, compensation or purchase prices paid by similarly situated organizations for similar specialties or medical practices, availability of similar services in the market, independent appraisal of all assets to be sold, and exclusion of inappropriate considerations such as referrals.

• The valuation opinion must be clear on how to use the results, subject to qualifications and limitations.

• The valuation consultant must understand the fraud and abuse regulations and fair market value parameters of the health care industry.

• Reviewing attorneys must consider that even a proper valuation does not establish the ultimate issue of the fair market value of the valuation figure itself and must guard against valuation methods that double-count assets, consider the impact of past or future referrals, assign value to intangible assets that produce no earnings or profits, or use overstated or understated assumptions as to future growth in cash flow or profits.

• The valuation cannot become stale.


Fair Market Value Compliance – Practical Considerations.

• Documentation – Health care providers and physicians should maintain documentation or a database of all new and existing arrangements to ensure that they do not violate Stark, Anti-Kickback or tax exempt law. The documentation must contain certain information for evaluating compliance including: 1) a copy of the arrangement (or its term, effective date, expiration date and automatic renewal provisions); 2) a description of the methodology used for the determination of fair market value of the compensation; 3) the amount of compensation, the method of payment, and whether the amount is based on the value or volume of referrals; and 4) whether the arrangement satisfies the requirements of an Anti-Kickback safe harbor, Stark exception and/or the procedures for a rebuttable presumption of reasonableness.

• Commercial Reasonableness – The arrangement must be a sensible, prudent business arrangement that involves a legitimate business purpose for the parties. The arrangement should be essential to the functioning of the healthcare provider for there to be a sound business reason for paying compensation to a referring physician. A regular assessment of the arrangement should be conducted to determine if it is still needed.

• Fair Market Value – The best evidence of fair market value is through independent fair market valuations or surveys of comparable transactions and circumstances. Rates of pay that exceed industry norms should be avoided unless circumstances caused by physician or specialty shortages or other market restrictions apply.

• Ongoing Monitoring – Payments are not fair market value unless actual services are being performed. All records and documentation of services performed must be accurate, complete and timely. Unusual patterns of reporting or suspicious issues should be investigated and oversight procedures implemented if necessary.

• Compliance Training – Health care providers should train management, other staff and physicians on the requirements of Anti-Kickback and Stark and other aspects of the organization’s compliance program. Training should occur within thirty (30) days of hire or the effective date of the arrangement with the physician, and annually thereafter. The training should also cover the provider’s policies and procedures for reviewing/approving physician contracts and compensation, the tracking of payments to physicians, and reporting obligations and forms.

1 INTERNATIONAL GLOSSARY OF BUSINESS VALUATION TERMS, The Institute of Business Appraisers, available at : http://www.go-iba.org/glossary.php.

2 69 Fed. Reg. 16,093 (March 26, 2004).

3 26 C.F.R. § 1.162-7(b)(3) (2004).

4 42 U.S.C. § 1395nn (2006).

5 Id. at (h) (6).

6 42 U.S.C. § 1395nn (h) (2006).

7 42 U.S.C. § 1395nn (h)(3) (2006).

8 42 C.F.R. § 411.351 (2006).

9 42 C.F.R. § 411.351 (2006).

10 42 C.F.R. § 411.357 (2006).

11 42 C.F.R. § 411.351 (2006).

12 42 C.F.R. § 411.351 (2006).

13 69 Fed. Reg. 16,128 (March 26, 2004).

14 Id.

15 Id.

16 See generally 66 Fed. Reg. 944-46. (Jan. 4, 2001).

17 Id. at 944.

18 Id.

19 Id. at 945.

20 Id.

21 See e.g. CMS PHYSICIAN SELF-REFERRAL REGULATIONS BACKGROUND, available at: http://www.cms.hhs.gov/PhysicianSelfReferral/02_regbackground.asp#TopOfPage . The Stark Phase I final rules were issued during 2001, Stark Phase II final rules were issued during 2004, and Stark Phase III rules are still forthcoming. Id.

22 202 F. Supp. 2d 671 (E. D. Mich. 2002).

23 Id. at 672-73.

24 Id. at 674.

25 Id. at 686-87.

26 United States ex. rel Roberts v. Aging Care Home Health, Inc., et. al., W.D. LA – Monroe Div., No. 02-2199, Feb. 16, 2007.

27 Renal Physicians Association v. U. S. DHHS, et. al., United States Court of Appeals, D.C. Cir., No. 06-5133, June 12, 2007.

28 United States of America ex. rel., Darryl L. Kaczmarczyk, et. al, v. SCCI Hospital Ventures, Inc. d/b/a SCCI Hospital Houston Central, U.S. District Court, Southern District of Texas, Houston, Division, No. H-99-1031, July 14, 2004.

29 “Fair Market Valuation of Medical Director or Program Director Services”, by Mayer Hoffman McCann and Kathy McNamara, filed with Plaintiff United States Designation of Expert Witness, July 12, 2005.

30 42 U.S.C. § 1320a-7b (b) (2006).

31 The mental state required to violate the Anti-Kickback laws is open to a number of interpretations. The most far-reaching approach of what may violate the statute is one that only requires that only “one purpose” of the conduct was to induce or solicit referrals. See U.S. v. Greber, 760 F.2d 68 (3rd Cir. 1985).

32 U.S. v. Greber, 760 F. 2d 68 (3rd Cir. 1985) cert. denied, 474 U.S. 988 (1985); U.S. v. Lipkis, 770 f. 2d 1447 (9th Cir. 1985); U.S. v. Kats, 871 F.2d 105 (9th Cir. 1989). “OIG Supplemental compliance Program Guidance for Hospitals”, Fed. Reg. Vol. 70, No. 19, 1/31/2005, p. 4854.

33 Hanlester Network v. Shalala, 51 F.3d 1390 (9th Cir. 1995).

34 Special Fraud Alert: Arrangements for the Provision of Clinical Laboratory Services, Office of Inspector General, October, 1994.

35 OIG Supplemental Compliance Program Guidance for Hospitals, p. 4866.

36 42 C.F.R. 1001.952 (b) and (c).

37 42 C.F.R. 1001.952 (b).

38 42 C.F.R. 1001.952 (c).

39 OIG Supplemental Compliance Program for Hospitals, p. 4876.

40 OIG Supplemental Compliance Program for Hospitals, p. 4866-67.

41 26 C.F.R. § 53.4958-1T, et. seq.

42 Health Care Provider Reference Guide, Internal Revenue Service, 2004 EO CPE Text, p. 16.

43 Id. at p.16.

44 Id. p. 16.

45 “Physician Incentive Compensation, Internal Revenue Service, 2000 EO (CPE Text, P.25-34.

46 Caracci v. Comm'r, 456 F.3d 444 (5th Cir. 2006).

47 Letter from D. McCarty Thorton, Associate General Counsel, Office of Inspector General (HHS) to T. J. Sullivan, Technical Assistant, office of the Associate Chief Counsel, Employee Benefits and Exempt Organizations, Dec. 22, 1992..

48 69 Fed. Reg. 16107.







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