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In Mayo Clinic v. US, No. 16-cv-03113 (D. Minn. Aug. 6, 2019), the US District Court for the District of Minnesota has granted Mayo Clinic's motion for summary judgment with respect to a refund of unrelated business income tax (UBIT). The IRS had contended that Mayo Clinic was not entitled to the refund because it was not an "educational organization" under IRC Section 170(b)(1)(A)(ii) and the regulations thereunder. Rejecting the IRS's position, the court concluded that the corresponding regulations impermissibly imposed additional requirements to qualify as an educational organization beyond those included in the statute.

Background

Unrelated business income and educational organizations

In general, tax-exempt organizations must pay tax on unrelated business income (UBI) under IRC Sections 511-514. An exclusion from UBI applies for certain types of passive income (e.g., from dividends, interest and real-property rents) unless such income is earned using borrowed money. A further exception allows passive income that is earned from debt-financed real property to be excluded from UBI in the case of a "qualified organization." Qualified organization for this purpose is defined in IRC Section 514(c)(9)(C) to include organizations described in IRC Section 170(b)(1)(A)(ii) (i.e., educational organizations).

Specifically, IRC Section 170(b)(1)(A)(ii) refers to: "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."

The corresponding Treasury regulation generally reiterates the statutory language with regard to an "educational organization," but also specifies that (1) formal instruction must be the "primary function" of the organization (primary-function requirement) and (2) any noneducational activities of the organization must be "merely incidental" to its educational activities (merely-incidental test).

Facts and procedural history

Mayo Clinic (Mayo) is a nonprofit, tax-exempt IRC Section 501(c)(3) organization that, among other things, operates five distinct medical schools. After an audit, the IRS determined that Mayo owed tax on certain income that it received from partnerships because, in the IRS's view, Mayo is not an "educational organization." Specifically, the IRS determined that Mayo is not an educational organization because its primary function is not formal instruction. Mayo paid the disputed taxes and filed a suit for refund in the amount of approximately $11 million.

The government conceded that Mayo met the explicit requirements of an educational organization under IRC Section 170(b)(1)(A)(ii) relating to faculty, curriculum, students and place. However, it contended that Mayo did not qualify as an educational organization under the intended meaning of the statute (in its interpretation) and the requirements of the corresponding Treasury regulation (i.e., the primary-function requirement and merely-incidental test). The government argued that Mayo's primary function was health care, not education, and, accordingly, under the IRS's statutory interpretation, it was not an educational organization.

Mayo disagreed with the government's interpretation of the law and contended that its health care and educational activities were both essential to its organization. Both parties filed cross-motions for summary judgment.

Opinion

The court explained that the summary-judgment motions required consideration of the relevant statute and regulation under Chevron (Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984)). Chevron sets forth a two-step framework for deciding if a regulation interpreting a statute is entitled to deference. In the first step, the court generally considers whether congressional intent is clear on the question at issue; if so, such intent controls. However, if Congress has not spoken to the precise question at issue, then the court will consider whether the agency regulation is based on a permissible construction of the statute. Specifically, in the current case, the court determined that the precise question at issue is whether the statute is silent or ambiguous with respect to the primary-function and merely-incidental requirements that appear in the regulation.

The court noted that IRC Section 170(b)(1)(A)(ii) contains no explicit primary-function requirement. However, the following subsection does include such language — IRC Section 170(b)(1)(A)(iii): "an organization the principal purpose or functions of which are the providing of medical or hospital care or medical education or medical research … " (emphasis added). Under settled rules of statutory construction, when Congress includes language in one subsection and not another, courts generally must interpret the distinction as intended and meaningful, not an oversight. The court noted that the government neither (1) identified any reason why the "principal purpose or functions" language was not included in the preceding statutory subsection (had that been congressional intent) nor (2) suggested that the "principal purpose or functions" language meant something different than the "primary function" language included in the regulations under subsection (ii). The court stated that IRC Section 170(b)(1)(A)(ii) "should not be understood implicitly to contain the very same requirement that is explicit in [subsection (iii)]".

Having determined that Congress unambiguously did not include a primary-function requirement in IRC Section 170(b)(1)(A)(ii), the court turned to the merely-incidental test. Analyzing the language of the test in the regulations, the court concluded that this additional test was merely another way of stating the primary-function requirement.

The court dismissed in turn a number of alternative arguments, concluding

1. Whether IRC Section 170(b)(1)(A)(ii) defines "educational organization" or describes a subset of such organizations does not affect the court's judgment regarding the impermissibility of the regulation's primary-function and merely-incidental requirements.
2. The term "educational organization" does not unambiguously imply an organization whose primary function is education.
3. Mayo is not precluded from qualifying for the UBI exclusion for IRC Section 170(b)(1)(A)(ii) educational organizations because it describes itself as an IRC Section 170(b)(1)(A)(vi) organization (or perhaps qualifies as an IRC Section 170(b)(1)(A)(iii) organization), because neither IRC Section 514 nor IRC Section 170 explicitly prevent an organization from qualifying under multiple subparagraphs of IRC Section 170(b)(1)(A).
4. The court's conclusion regarding the significance of the explicit inclusion of a primary purpose test in in IRC Section 170(b)(1)(A)(iii) but not subsection (ii) controls, despite what might be implied in language included in other Sections of the Code which were enacted at different times.
5. The legislative history does not speak directly to the precise question at issue.

Accordingly, the court determined that the primary-function requirement and merely-incidental test exceed the bounds of authority of the statute. Because Mayo meets the requirements described in IRC Section 170(b)(1)(A)(ii), the court held it is entitled to the refund sought.

Implications

This decision primarily affects those organizations that meet the definition of IRC Section 170(b)(1)(A)(ii) but whose primary function is not education. Organizations that can meet the explicit requirements of "faculty, curriculum, students and place" as outlined in IRC Section 170(b)(1)(A)(ii) may have a refund opportunity available for UBI reported as debt-financed rental income regardless of their primary purpose. Therefore, exempt organizations that have not previously claimed the exemption from UBI available pursuant to IRC Section 514(c)(9) should review their facts to determine if they qualify as an "educational organization" under the specific language of IRC Section 170(b)(1)(A)(ii).

Please contact your Ernst & Young LLP professional for further information.

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