Like Peas in a Pod?
What do private, not-for-profit colleges and hospitals have in common?
There are quite a few items that come immediately to mind:
- They may qualify for exemption from federal income tax.[i]
- Tax-exempt colleges and hospitals are classified as public charities, per se, for purposes of the Code regardless of their sources of support.[ii]
- Although generally exempt from income tax, they are subject to tax on income derived from a trade or business regularly carried on by the organization that is not substantially related to the organization’s tax-exempt functions.[iii]
- That said, colleges and some hospitals may enjoy an exemption from tax on certain types of unrelated business income that is denied most other exempt organizations.[iv]
- Both institutions are often major employers and economic drivers for the communities in which they are located,[v] the practical and political considerations of which cannot be overstated.
- They seek to improve the lives of the individuals and communities they serve, at least in theory.
- Both have steadily and significantly increased the amounts they charge these individuals for these services.[vi]
- Members of the public, and many of their elected representatives, have questioned whether the benefits bestowed upon them by these institutions are commensurate with the amounts charged to the public for their services.
- Many in Congress who have compared (i) the economic benefits enjoyed by colleges and hospitals by virtue of their exempt status with (ii) the community investment made by these institutions, have questioned whether their continuing tax-exempt status is justified.[vii]
- Over the years, Congress has taken various half-measures to curtail some of the abuses that have been brought into the public light.
Excess Benefits. For example, in 1996, legislation was enacted to deter and punish the transfer of a so-called “excess economic benefit” from a public charity to a so-called “disqualified person.” This provision targeted the direct or indirect transfer by the charity of an amount that exceeds the value of the consideration (including the performance of services) received by the charity in exchange for providing such benefit.[viii]
CHNA. In 2010, a new requirement for tax-exempt status was added to the Code for organizations that operate one or more hospital facilities.[ix] In addition to the general requirements for tax exemption, a hospital organization must meet the following requirements on a facility-by-facility basis: the hospital organization must conduct a community health needs assessment (CHNA) every three years and must adopt an implementation strategy to meet the community health needs identified through the CHNA; the hospital organization must establish written financial assistance policy (FAP) and emergency medical care policies for a hospital facility it operates, and which includes, among other things, the method for applying for financial assistance; limits the amount charged for any emergency or other medically necessary care it provides to a FAP-eligible individual; and requires a hospital organization to make reasonable efforts to determine whether an individual is eligible for assistance under the hospital organization’s FAP before engaging in “extraordinary collection actions” against that individual.
Executive Compensation. In 2017, a new 21 percent excise tax was added to the Code, which would be imposed on a public charity based on the amount by which the compensation paid to any of the charity’s five most highly compensated employees during the taxable year exceeded $1 million.[x]
Endowment Tax. That same year, a new tax was introduced with respect to certain private colleges, equal to 1.4 percent of the college’s net investment income for a taxable year when the aggregate fair market value of the college’s investment assets at the end of such year is at least $500,000 per student.[xi]
Based on just the foregoing, one might surmise that the Code is skewed against hospital and colleges. Before jumping to such a conclusion, however, one must first appreciate the outsized role that hospitals and colleges play in our economy.[xii]
One must also understand the many economic benefits that the Code reserves for such organizations and how jealously they guard their continued access to such benefits.
The recently concluded dispute between the Mayo Clinic (“MC”) and the IRS, over whether the former qualified for an exemption to the general rule that treats debt-financed income as unrelated business income,[xiii] illustrates (i) the lengths to which such a charity is willing to go to secure what it believes is its right to an economic benefit under the Code, as well as (ii) the IRS’s doggedness in resisting what it genuinely believes is an inappropriate claim.
Mayo Clinic – In Brief
MC is a nonprofit corporation under state law and is exempt from federal income tax under Sec. 501(c)(3) of the Code. It is the parent organization of many hospitals and clinics. It is also the parent of the MC College of Medicine and Science, which is comprised of five distinct medical schools.
According to its annual federal group tax return for the tax year ending December 31, 2019[xiv] – which did not include all subordinate organizations – MC reported almost $33 million of unrelated business revenue, total revenue of almost $10.5 billion, net revenue of over $465 million, total assets of more than $15.5 billion, and net assets in excess of $7 billion.
Disagreement with the IRS
In 2009, after conducting an audit of MC’s tax returns for several years, the IRS issued a Notice of Proposed Adjustment asserting that MC owed income tax on certain income it received from partnerships. The Service concluded that MC was not entitled to a tax exemption with respect to this partnership income because, according to the IRS, MC was not an “educational organization.”
Then, in 2013, the Office of Chief Counsel issued a Technical Advice Memorandum confirming the IRS’s position that MC did not qualify as an educational organization.[xv]
At that point, MC paid the disputed taxes, filed a timely claim for refund with the IRS (which was denied), and, in 2016, filed a timely lawsuit in federal District Court seeking a refund of more than $11.5 million.
Before delving into the basis for MC’s refund claim, a brief review of the unrelated business income tax is in order.
Unrelated Business Income
In general, tax-exempt organizations are not subject to federal income tax with respect to income generated in the performance of the function on the basis of which their exempt status was granted. Thus, a college is not taxable on the tuition it charges its students in exchange for teaching them. Similarly, a hospital is not taxable on the fees it charges its patients in exchange for providing medical care.
Exception to the Exemption
However, an otherwise exempt organization may still be liable for tax on its unrelated business income, which is income from a trade or business, regularly carried on, that is not substantially related to the exempt purpose that is the basis of the organization’s tax exemption.
Exclusion from the Exception
Still, the Code permits tax-exempt charitable organizations to exclude from their unrelated business income certain types of passive investment income, such as dividends, interest, and rent from real property.[xvi]
Exception to the Exclusion
That said, there is an exception to this exclusion: if an organization’s passive income is earned using borrowed money – i.e., it is derived from property with respect to which there is acquisition indebtedness (“debt-financed property”) – then the amount of income excluded from unrelated business income is reduced.[xvii]
Exception to the Exception
But even if the passive income comes from debt-financed real property, the income may be excluded from unrelated business income if the organization is a “qualified organization.”[xviii]
According to the Code, a qualified organization is “an educational organization which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.”[xix]
However, the IRS has issued regulations[xx] that include two additional requirements for “qualified organization” status that do not appear in the Code. Specifically, the organization’s “primary function is the presentation of formal instruction and it normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on. . . . It does not include organizations engaged in both educational and noneducational activities unless the latter are merely incidental to the educational activities.”
District Court: Round One[xxi]
The IRS conceded that MC “normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.”
Notwithstanding this concession, the IRS relied upon the two additional above-mentioned regulatory requirements for its conclusion that MC was not an educational organization and, therefore, could not be a qualified organization for purposes of the exception for debt-financed real property pursuant to which income can be excluded from unrelated business income. Specifically, the IRS asserted that MC failed to satisfy the “primary function” and “merely incidental” tests.
Predictably, MC challenged the validity of the regulation.
After considering cross motions for summary judgement, the District Court agreed with MC. Applying Chevron’s[xxii] framework for deciding whether an agency’s regulation interpreting a statute is entitled to deference, the Court concluded that the “regulation does more than the law allows because it adds requirements – the primary-function and merely-incidental tests – Congress intended not to include in the statute.”
The IRS appealed the District Court’s decision to the Eighth Circuit Court of Appeals,[xxiii] which agreed with the lower court that the regulation in question added “unreasonable conditions to the statutory requirement that a qualified educational organization is one ‘which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.’” Specifically, the Court continued, the regulatory requirement that the organization’s primary function must be “‘the presentation of formal instruction’ has no long history of congressional acceptance.”
However, the Court also added that the terms “primary function” and “merely incidental” have a “valid role in interpreting the statute” and, in particular, the term “educational organization.”[xxiv] It explained that the Code,[xxv] for purposes of the term “charitable contribution,” refers to an entity that is “organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes.” The term “educational organization,” it continued, is used to identify a specific type of entity in the “charitable contribution” definition. Therefore, an “educational organization” must be “organized and operated exclusively for … educational purposes.”
The settled judicial interpretation of “organized and operated exclusively,” the Court stated, includes organizations whose “primary purpose” was one or more qualifying charitable uses, and whose noncharitable activities were “merely incidental” to those purposes. The Court observed that Congress was obviously aware of the judicial non-literal construction of the word “exclusively” when it enacted the UBIT exception.
According to the Court, it is reasonable and necessary that an “educational organization” be construed as one that is “organized and operated exclusively for” one or more qualifying charitable uses.
Moreover, it is valid, the Court continued, to interpret the Code as requiring that a qualifying organization’s primary purpose must be “educational” and that its noneducational activities be merely “incidental to that primary purpose.”
What About MC?
Turning to MC, the Court stated that whether the organization was an educational organization was a “mixed question of law and fact,” and explained that,
“[t]he analysis normally unravels in three parts: (1) whether the taxpayer is “organized and operated exclusively” for one or more exempt purposes; (2) whether the taxpayer is “organized and operated exclusively” for educational purposes; and (3) whether the taxpayer meets the statutory criteria of faculty, curriculum, students, and place. Failure to satisfy any part renders the taxpayer ineligible for the UBIT exemption provided to [qualified] organizations. The government concedes that [MC] satisfies the first criteria. Further, by virtue of the [College], the government also concedes the third criteria.”
In short, it must be determined whether MC’s overall purpose and operations establish that it was “organized and operated exclusively” for educational rather than other purposes.[xxvi] That some of its educational purposes and functions also fall within other charitable categories – and vice versa – would not disqualify it from being an educational organization, but “the presence of a single non-educational purpose, if substantial in nature, will destroy the [UBIT] exemption regardless of the number or importance of truly educational purposes.” Thus, the balance is educational against noneducational.
The Court concluded that the statute could not be applied to MC on the record before it. First, how to measure educational activity as opposed to noneducational activity, as well as the degree to which education must be MC’s primary purpose, were disputed by the parties.[xxvii] Second, MC’s status as an academic medical center meant that its medical and educational purposes – and the operations supporting those functions – were inextricably intertwined. “Separating . . . the educational from the noneducational . . . while difficult, is not impossible.”
With that, the Eighth Circuit reversed the district court’s ruling that the regulations were invalid in their entirety, and remanded the case to the district court to consider the above-referenced issues of fact and law.
Action on Decision
It wasn’t long after the Eighth Circuit reversed and remanded to the district court, concluding that the IRS’s regulation was valid, in part, that the IRS announced that it disagreed with the Court’s decision.[xxviii]
Specifically, the IRS disagreed with the Court’s invalidation of the regulatory requirement that the primary function of an educational organization must be formal instruction.
The IRS recognized that the Court’s decision was precedential for cases appealable to the Eighth Circuit and stated that it would follow the decision for such cases.
However, the IRS concluded by adding that it would continue to litigate the “formal instruction” requirement in cases in other circuits.
District Court: Round Two[xxix]
Following a bench trial, the District Court entered judgment for MC based on its findings that MC was organized and operated exclusively for educational purposes and had no noneducational purpose that was substantial in the relevant sense.
The Court agreed with MC that its system-wide activities (not just MC’s activities as a parent corporation) had to be analyzed for the purpose of determining MC’s primary purpose. These activities, it stated, were highly integrated, both structurally and financially. Moreover, the Court found that MC’s governing documents granted MC broad affirmative powers over its subsidiaries, and the subsidiaries’ governing documents reserved all substantial decisions for MC. In addition, MC’s executives had system-wide responsibilities.
Next, the Court concluded that the term “primary” should be interpreted as meaning a “substantial purpose” of the organization – not the “most important purpose” of the organization.
Having set the framework for its analysis, the Court turned to the very detailed factual record, which included an in-depth description of the schools operated under MC.
On the basis of this record, the Court concluded that “enterprise-wide,” MC integrates education, research, and clinical practice: MC was founded with the purpose of providing quality medical education; its articles of incorporation, its bylaws, and its governance documents reflect its substantial educational purposes; its mission statement similarly reflects this substantial educational purpose; MC’s educational purposes are also reflected in its day-to-day operations;[xxx] and MC’s finances illustrate that education is a substantial purpose of the organization.[xxxi]
The Court rejected the IRS’s argument that MC’s educational purposes were insubstantial because MC earned more from patient care than it did from its educational offerings. According to the Court, “this argument misses the rest of the system-wide activities”; the better approach, it continued, was to consider the revenue and expense numbers on a net basis, especially in light of the Court’s finding that MC’s educational functions were inextricably intertwined with its other functions.
Next, the Court dismissed the IRS’s assertion that every MC activity had to be evaluated on its own, as either entirely educational or noneducational – not as part of several integrated activities. According to the Court, if a particular activity furthers both educational and noneducational purposes, that activity may still be “exclusively” educational – applying the “judicial nonliteral construction” of the word – for purposes of applying the UBIT exemption. The relevant inquiry, the Court added, is not whether a particular activity has some purpose in addition to education, but whether a particular function has no educational purpose and is a substantial part of MC’s organizational purpose.
The IRS pointed out that MC’s “organizational documents reveal that, during the refund years, [MC] was authorized to engage in a wide range of activities, and not only educational activities,” thereby inferring that the mention of noneducational activities in MC’s organizational documents shows a substantial noneducational purpose. The IRS also suggested that either patient care, patient outcomes, or the practice of medicine were substantially important to MC; in other words, that these were substantial noneducational purposes that would prevent MC from being treated as a qualifying organization.
The Court found that the IRS’s position with respect to these documents was not persuasive. Any purpose – including health care or patient care – will not render MC ineligible for the UBIT refund unless it is (1) substantial and (2) noneducational. While acknowledging that patient care is certainly substantial, it is “not noneducational” because MC integrates education and clinical practice.
The IRS also claimed that MC’s research and laboratory testing functions did not have an educational component. The Court disagreed, finding that research was a critical part of the education of many students, that students were heavily involved in laboratory testing for purposes of learning pathology and conducting research, and that diagnostic testing was incidental to the “patient care necessary to render education to” MC’s residents.
Finally, the IRS argued that expenditures such as maintaining physical facilities, human resources, and other such administrative tasks, disqualified MC from the UBIT exemption. However, the Court found that these administrative functions, were neither substantial nor noneducational. If MC’s administrative services could be considered substantial, they supported its educational purpose. Administration is never conducted for its own sake, the Court stated; instead, such functions necessarily serve an organization’s purposes. Administration is necessarily incidental to educational purposes if it supports those educational services.
For all the foregoing reasons, the District Court determined that MC is an “exclusively” educational organization that was entitled to the UBIT exemption. Thus, MC was entitled to judgment in its favor on its refund claim, together with statutory interest.
The District Court – which had previously invalidated the above-referenced IRS regulation in its entirety, and to which the Eighth Circuit had remanded MC’s case for the purpose of determining whether MC’s primary function was educational – decided to evaluate each of MC’s separate activities as one of several integrated activities at the core of which was MC’s schools.
The Court’s approach – which at times seemed strained[xxxii] – together with its nonliteral construction of the statutory language that described the type of organization to which the UBIT exemption was intended to apply, necessarily led to the conclusion that MC was a qualified organization and was entitled to its claim for refund.
This is good news for teaching hospitals and academic medical centers – at least within the Eighth Circuit – that can demonstrate the same degree of “integration” among their educational, medical, research, and other activities as the Court determined was present in MC’s case.
Of course, the IRS has indicated that it will continue to contest claims under the UBIT exemption that are made by hospital organizations located outside the Eighth Circuit.
It’s only a matter of time before the IRS has another opportunity to defend its position. Stay tuned.
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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] IRC Sec. 501(a) and Sec. 501(c)(3).
[ii] IRC Sec. 509(a)(1) and Sec. 170(b)(1)(A)(ii)-(iii).
[iii] IRC Sec. 511-514. The unrelated business income tax (“UBIT”).
[iv] IRC Sec. 514(c)(9)(C); “qualified organizations.” More on this later.
[v] Northwell Health is the largest employer on Long Island, New York; Catholic Health Services is the third largest. Columbia University is the second largest private employer in Manhattan.
[vi] You may have read recently how some colleges, following the President’s announcement to forgive some student debt – with which I strongly disagree – have increased tuition. WTF. How about dealing with the tuition and those charging it instead?
[vii] Senator Grassley’s name often comes up in this context.
[viii] IRC Sec. 4958; P.L. 104-168.
[ix] IRC Sec. 501(r); P.L. 111-148. In addition, new reporting requirements and a new excise tax were also enacted.
[x] IRC Sec. 4960; P.L. 115-97. Football and basketball coaches were among the targets. Don’t get me started.
[xi] IRC Sec. 4968; P.L. 115-97. Well-endowed private colleges squealed like stuck pigs.
[xii] In 2021, combined U.S. national health and post-secondary expenditures as a share of gross domestic product exceeded 20 percent.
[xiii] IRC Sec. 514.
[xiv] The latest available on Guidestar.org.
[xv] A technical advice memorandum, or TAM, is guidance furnished by the Office of Chief Counsel upon the request of an IRS director or an area director, appeals, in response to technical or procedural questions that develop during a proceeding. A request for a TAM generally stems from an examination of a taxpayer’s return, a consideration of a taxpayer’s claim for a refund or credit, or any other matter involving a specific taxpayer under the jurisdiction of the territory manager or the area director, appeals. Technical Advice Memoranda are issued only on closed transactions and provide the interpretation of proper application of tax laws, tax treaties, regulations, revenue rulings or other precedents. The advice rendered represents a final determination of the position of the IRS, but only with respect to the specific issue in the specific case in which the advice is issued.
[xvi] IRC Sec. 512(b).
[xvii] IRC Sec. 514.
[xviii] IRC Sec. 514(c)(9)(A).
[xix] IRC Sec. 514(c)(9)(C); IRC Sec. 170(b)(1)(A)(ii).
[xx] Reg. Sec. 1.170A-9(c).
[xxi] 412 F. Supp.3d 1038 (D. Minn. 2019).
[xxii] Chevron USA, Inc. v. Natural Resources Defense Council, Inc. 467 U.S. 837 (1984).
[xxiii] 997 F. 3d 789 (8th Cir. 2021).
[xxiv] But the Court also cautioned that they do not establish the validity of the regulatory requirement that the “primary function” be the presentation of formal instruction.”
[xxv] IRC Sec. 170 – the same provision to which the UBIT exception for qualified organizations refers.
[xxvi] The third requirement.
[xxvii] The government relies on expenses and revenue disclosed on Mayo’s Forms 990, while Mayo emphasizes a totality of the circumstances approach. Additionally, the government believes that education including the operation of medical schools must be the § 501(c)(3) taxpayer’s principal or most important purpose while Mayo contends it need only be substantial.
[xxviii] AOD-2021-04, Nov. 22, 2021.
[xxix] 2022-2 USTC P 50,266 (D. Minn. 2022).
[xxx] MC operates five accredited schools; it maintains, manages, and pays the schools’ faculty members; the vast majority of physicians at MC hold faculty appointments, thus demonstrating that they are not mere health care providers but educate through health care; The facilities at MC are predominantly used for educational purposes, and the medical treatment and research at MC nearly always serves an educational purpose (even when involving students renders health care more expensive).
[xxxi] Each year, it conducted its educational activities at a loss.
[xxxii] Read the decision for yourself to see how easily almost every MC activity could be treated as having an important educational component.