In Mayo Clinic v. US, the Eighth Circuit has reversed and remanded a district court's summary judgment decision for the Mayo Clinic, concluding that Reg. Section 1.170A-9(c)(1) is partially valid and how IRC Section 170(b)(1)(A)(ii) (which defines an educational organization) applies to the Mayo Clinic's tax years at issue cannot be determined based on the record currently before the court.

Background

Unrelated business income (UBI) and educational organizations

Tax-exempt organizations generally must pay tax on UBI under IRC Sections 511-514. Certain types of passive income (e.g., from dividends, interest and real-property rents) are excluded from the general rule, unless this income is earned using borrowed money. Passive income earned from debt-financed property, however, may be excluded from UBI if the taxpayer is a "qualified organization," defined in IRC Section 514(c)(9)(C) as including educational organizations described in IRC Section 170(b)(1)(A)(ii). Specifically, IRC Section 170(b)(1)(A)(ii) refers to "an educational organization [that] 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 lower-court decision

The Mayo Clinic (Mayo) is a 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" in that its primary function is not formal instruction. Mayo paid the disputed taxes and sued for refund, totaling approximately $11.5m.

In federal district court, the IRS argued that Mayo was not entitled to a refund of unrelated business income tax (UBIT) because it was not an educational organization under IRC Section 170(b)(1)(A)(ii) and its regulations. The district court found that the primary-function requirement and merely incidental test exceeded the statute's authority. Because Mayo met the requirements described in IRC Section 170(b)(1)(A)(ii), the court concluded that it was entitled to the refund. The district court granted summary judgment for Mayo, concluding that the regulations impermissibly imposed additional requirements to qualify as an educational organization beyond those included in the statute. (For more on the district court opinion, see Tax Alert 2019-1464.)

Appellate decision

Reviewing the district court's decision de novo, the Eighth Circuit framed the question at issue as whether Mayo constitutes a "qualifying organization" exempt from paying UBIT under IRC Section 514(c)(9)(C)(i). A qualified organization includes an organization described in IRC Section 170(b)(1)(A)(ii), 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 appeals court explained. The district court had held Reg. Section 1.170A-9(c)(1) as invalid because it adds requirements, namely the primary-function and merely incidental tests, that "Congress intended not to include in the statute," the Eighth Circuit noted.

On appeal, the Government argued that (1) the regulation is a valid interpretation of the term "educational organization," as defined in the code, and (2) applying the regulation at issue, the Government is "entitled to summary judgment because Mayo is not an educational organization as a matter of law."

In evaluating the validity of Reg. Section 1.170A-9(c)(1), the Eighth Circuit noted that the lower court primarily relied on the Russello principle, which provides that, "[w]hen Congress includes particular language in one section of a statute but omits it in another — let alone in the very next provision — this Court presumes that Congress intended a different meaning." Applying the Russello principle, the lower court concluded that Congress intended the primary purpose or function test to apply to IRC Section 170(b)(1)(A)(iii) organizations providing "medical or hospital care or medical education or medical research" and not to IRC Section 170(b)(1)(A)(ii) educational organizations.

The appeals court found that (1) the Russello principle was relevant but not controlling and (2) the district court should have put more weight on "the origins of the statutory charitable exemption and the Treasury Regulation at issue, and the manner in which the current statutory provisions have been added to the IRC and modified over more than a century."

After recounting the applicable legislative history, the appeals court reached several conclusions. It agreed with the district court that Reg. Section 1.170A-9(c)(i) "adds unreasonable conditions to the statutory requirement that a qualified educational organization is one [that] '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 circuit court characterized this aspect of the regulation as having "the earmarks of an agency interpretation intended to nullify a statutory benefit the Treasury Department unsuccessfully opposed."

The appeals court found that (1) the regulation unreasonably limits the definition of "educational organizations" to those that principally provide formal instruction, but (2) the regulation's use of "primary function" and "merely incidental" to describe types of activities "have a valid role in interpreting the statute." An educational organization under IRC Section 170(b)(1)(A)(ii) must be organized and operated exclusively for educational purposes. Based on the "settled judicial interpretation of 'organized and operated exclusively,'" IRC Section 170(b)(1)(A)(ii) is intended to describe organizations that have education as their primary purpose and noneducational activities, if any, that are merely incidental, the court explained.

The next question for the court was how IRC Section 170(b)(1)(A)(ii)'s requirement for the taxpayer to be an educational organization — an IRC Section 501(c)(3) entity with education as its primary activity — applied to Mayo. The issue of whether Mayo qualifies as an educational organization "is a mixed question of law and fact," which neither party directly addressed on appeal. To make such a determination, a three-part analysis is typically applied, the court explained. (1) Is the taxpayer organized and operated exclusively for one or more exempt purposes? (2) Is the taxpayer organized and operated exclusively for educational purposes? And, (3) does the taxpayer meet the statutory criteria of faculty, curriculum, students and place? Only the second criterion remained at issue. Concluding that more information is needed to determine whether Mayo meets the second criterion, the court remanded the case to the district court.

A separate, concurring opinion agreed with the court's conclusion but took issue with its emphasis on legislative history, saying "none of it is necessary to determine what the phrase 'educational organization' means."

Implications

The opinion, while nominally reaffirming the Court's deference to the Treasury Department in its interpretation of the Internal Revenue Code, highlighted the Court's willingness to correct a regulation that it viewed as circumventing congressional intent. In holding that some of the language in Treasury Reg. 1.170A-9(c)(i) contains "unreasonable conditions" that are not supported by either jurisprudence or legislative history, the Eighth Circuit has effectively expanded the definition of "qualified organization" under IRC Section 170(b)(1)(A)(ii) to include educational organizations that do not present "formal instruction." The Court cites nonprofit educational magazines and museums dedicated to educating the public as examples of organizations that established a tax-exempt "educational purpose." Accordingly, tax-exempt organizations whose primary purpose is educational, but that do not offer formal instruction, might be able to avail themselves of the exemption for unrelated business taxable income from debt-financed income under IRC Section 514(c)(9)(C)(i).

The decision also solidifies the prevalent interpretation of IRC Section 170(b)(1)(A)(ii), clarifying that Congress intended to limit the charitable tax advantage provided by IRC Section 170(b)(1)(A)(ii) only to organizations "organized and operated exclusively" for educational purposes under IRC Section 501(c)(3). This means that a qualifying organization's primary purpose must be "educational" and its noneducational activities must merely be incidental to that primary purpose. If, instead, an organization conducts both educational and noneducational activities that are substantial in nature, it will not fall within the definition of "educational organization."

The Eight Circuit opinion also sets out a blueprint for organizations to more readily determine if they qualify as an "educational organization" under the regulation. This thorough analysis of legislative history, intent, and statutory interpretation can serve as a helpful guide to taxpayers.

Ultimately, by invalidating the specific requirement of "formal instruction" found in the Treasury regulation, decisions whether an organization meets the definition under IRC Section 170(b)(1)(A)(ii) will become more fact-intensive. Thus, organizations that wish to avail themselves of the provisions in IRC Section 514(c)(9)(C) should review their facts in light of the analysis provided in this decision.

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