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The U.S. District Court for the District of Minnesota held (Mayo Clinic v. United States) that Mayo, a teaching hospital, is entitled to an $11.5m refund of unrelated business income tax (UBIT) on income from certain debt-financed real property. The court noted that Mayo is entitled to a refund during 2003, 2005–2007 and 2010–2012 (the tax years at issue) because "Mayo's overall purpose and operations establish that it is 'organized and operated exclusively' for educational rather than other purposes."

Background

Tracing Mayo's roots back to its founding in 1863, the court found that education had "been an integral part of the Mayo Clinic mission from its earliest days," stemming from the Mayo brothers' "deep commitment to education and research."

Initially granted tax-exempt status in 1969 as an organization described under IRC Section 501(c)(3), Mayo began acquiring various clinics and hospitals within a 200-mile radius of Rochester, Minnesota in 1990 and became known as the Mayo Clinic Health System (MCHS). Following a merger in 2010, Mayo Clinic Rochester was the service-wide parent for a handful of Mayo Clinic hospitals in Minnesota, Florida and Arizona.

The court cited various facts reflecting Mayo's educational purpose during the tax years at issue, including:

• Mayo's articles of incorporation and bylaws, which emphasize the importance of integrating education, research and clinical practice
• The CEO's responsibility for setting system-wide funding levels for education
• Mayo's Education, Research and Clinical Practice Committees, which further system-wide integration so that "every initiative, old or new, was reviewed to determine if it effectively integrated education, research, and clinical practice"

During the tax years at issue, Mayo operated five schools to train healthcare professionals: (1) Mayo Clinic School of Graduate Medical Education; (2) Mayo Clinic School of Medicine; (3) Mayo Clinic School of Health Sciences; (4) Mayo Clinic School of Continuing Professional Development; and (5) Mayo Clinic Graduate School of Biomedical Sciences. Enrolled students were taught in many environments (e.g., classrooms, hospital wards, laboratories). Students included medical residents and fellows (doing post-graduate training), medical students, nurses, licensed physicians (earning continuing medical education hours), medical support staff and administrators. Most paid tuition, although medical residents and fellows were not charged tuition and typically were paid a small stipend for their clinical work.

The court evaluated the importance of education at Mayo by considering five factors: (1) quality of its programs and schools; (2) growth of its schools; (3) willingness to invest substantially in that growth; (4) worldwide profile of its schools; and (5) institutional expectations regarding the support of education. Considering the worldwide reputation of the Mayo Clinic, the high level of education and training it has offered, and the emphasis placed on education throughout the organization, the court found that Mayo met all five factors. Importantly, the court noted that Mayo expects each of its attending physicians (employees) to participate in education, research activities and clinical practice, and all are expected to obtain academic rank (i.e., assistant professor, associate professor, etc.).

The Forms 990 that Mayo filed during the tax years at issue limited Mayo to checking one box to explain why it was not a private foundation. Rather than choosing the box indicating it was a school, Mayo selected the box indicating that it normally receives a substantial part of its support from the public or a governmental unit. Mayo made this choice because selecting this public support box "allowed Mayo to report information on its Form 990 that its donors needed." Mayo explained in its Forms 990 "that it also is a school."

Refund suit

Mayo sought a refund of $11,501,621 in UBIT it had paid for the tax years at issue. In general, IRC Sections 511-514 require tax-exempt organizations to pay tax on unrelated business income (UBI). An exclusion from UBI applies for certain types of passive income (e.g., from dividends, interest and real-property rents) unless the tax-exempt organization acquired or improved the property from which that income is earned using borrowed money (debt-financed property). A further exception excludes from UBI passive income that is earned from debt-financed real property by 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." Treas. Reg. Section 1.170A-9(c)(1) also requires that the organization's "primary function" be educational and that any noneducational activities it engages in be "merely incidental" to its educational activities for it to qualify as an educational organization.

Despite conceding that Mayo meets the faculty, curriculum, students, and place requirements of IRC Section 170(b)(1)(A)(ii), the government argued that Mayo's primary function was health care, not education. Mayo contended that its health care activities were an integral part of and necessary to its educational mission.

The court determined that "primary" means "substantial" in determining an organization's primary purpose or function for purposes of IRC Section 170(b)(1)(A)(ii) and Treas. Reg. Section 1.170A-9(c)(1). Under this reasoning, an organization may have more than one primary purpose (e.g., educational, charitable). The court also noted that whether Mayo had a primary/substantial educational purpose during the tax years at issue should be determined by looking at its system-wide activities, rather than simply at the parent entity's activities, given how closely integrated Mayo's system is.

Next, the court determined that, on a system-wide basis, Mayo had a substantial educational purpose during the tax years at issue. The court rejected the government's assertion that Mayo's educational purposes "were insubstantial because it earned more from patient care than it did from its educational offerings." In analyzing Mayo's purpose, one must look not just at the parent entity's activities but at the system-wide activities, the court emphasized. The court was "not persuaded by the Government's argument that revenue relating to patient care shows that education is not a substantial purpose of the organization." As an organization with a teaching hospital, Mayo furthers its educational purpose through patient care activities, the court said.

Citing prior decisions involving Mayo in this litigation, the court said it joined "every court to have reviewed the issue in finding that Mayo's educational functions are inextricably intertwined with its other functions." The facts in this case "demonstrate what each of these courts independently concluded: education, research, and clinical practice are inextricably intertwined. In other words, health care, like Mayo's other functions, also serves educational functions, and educational functions are intertwined with every other Mayo function," the court concluded.

Having concluded that Mayo's provision of health-care services is inextricably linked to its educational purpose, the court ultimately found that Mayo has no substantial noneducational purpose. As a result, the court held that Mayo did not owe UBIT on certain debt-financed income it received in the tax years at issue because it qualified as an educational organization under IRC Section 170(b)(1)(A)(ii) and, accordingly, the government must refund the $11,501,621 Mayo paid as UBIT, plus statutory interest.

Implications

The district court's favorable ruling for Mayo provides a basis for tax-exempt hospitals and health systems with educational activities to take a position that they qualify for the debt-financed real property UBIT exemption under IRC Section 514(c)(9)(C)(i) as "educational organizations." In particular, under the court's reasoning that "primary" means "substantial," even if a majority of a health system's activity involves patient care, it may qualify as an educational organization if its educational purposes are substantial. The court found it significant that "education is at the heart of what Mayo does every day" and that its educational purposes and activities are integral to and interrelated with its patient care and research activities. Tax-exempt hospitals and health system parents that have a similar integration of educational and patient care/research activities, such as those with teaching hospitals and academic medical centers, may also be able to qualify as educational organizations for purposes of IRC Section 514(c)(9)(C)(i) under the district court's interpretation of that term.

Technically, the only hospitals that the district court's ruling applies to are those in Minnesota; the IRS is not required to follow the ruling outside of the District of Minnesota.

In the prior opinion in the Mayo litigation, the Eighth Circuit invalidated the requirement in Treas. Reg. Section 1.170A-9(c)(1) that an educational organization's primary function must be to provide formal instruction, but upheld the regulation's requirement that the primary purpose of the organization must be educational. (See Tax Alerts 2021-1023 and 2019-1464.) The Eighth Circuit remanded the case to the district court to determine whether Mayo met this primary purpose requirement. The IRS responded with an Action on Decision (AOD 2021-04) stating it will not acquiesce in the Eighth Circuit's invalidation of the requirement that the primary function of an "educational institution" must be formal instruction, other than in the Eighth Circuit (consisting of Minnesota, North Dakota, South Dakota, Nebraska, and parts of Arkansas, Missouri and Iowa). (See Tax Alert 2021-2202.) It is possible that the IRS will release a subsequent AOD in response to the district court's latest ruling, stating that it will not acquiesce to the district court's broad definition of "primary purpose" in its decision, other than in the District of Minnesota.

As such, tax-exempt hospitals and health systems outside of the District of Minnesota that engage in educational activity may face an uphill battle trying to convince the IRS that they are "educational organizations" that qualify for the IRC Section 514(c)(9) UBTI exception for income derived from debt-financed real property. If the IRS were to challenge a health-care organization's claim (e.g., for refund of UBIT, Form 8940 application for reclassification of public charity status, etc.) that it qualifies as an educational organization, that organization could consider following Mayo's example in litigating the issue.

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Published by NTD’s Tax Technical Knowledge Services group; Carolyn Wright, legal editor