The New Jersey Tax Court recently held that a nonprofit hospital was not entitled to an exemption from property tax assessed by the town of Morristown for the 2006-2008 tax years because the hospital failed to provide evidence that the operation and use of its property was entirely conducted under a nonprofit motive.1 Focusing on a popular topic in the area of property tax, the Tax Court thoroughly considered the applicability of the nonprofit hospital's entire property tax exemption. Following the decision, the hospital settled the litigation with Morristown for $15.5 million in payments over a ten-year period.
Background
Morristown Memorial Hospital first opened in 1893 and operated on a 1.1 million square foot campus in Morristown, New Jersey. The hospital provided a comprehensive range of medical services and maintained 700 hospital beds. Because the property which contained the hospital was exempt from property taxes prior to 2006, it had not previously been assessed for property tax purposes.
The hospital claimed a statutory exemption for the property of nonprofit organizations for the 2006-2008 tax years.2 Interpreting this statutory exemption in Paper Mill Playhouse v. Millburn Township,3 the New Jersey Supreme Court had previously adopted three criteria that must be met for a hospital to receive the exemption: (i) the subject property must be owned by an entity organized exclusively for a tax-exempt purpose (the "organization" test); (ii) nearly all of the subject property must actually be used for hospital purposes (the "use" test); and (iii) its operation and use of property must not be conducted for profit (the "profit" test).
The town of Morristown levied omitted assessments on the property owned by the hospital for the 2006 and 2007 tax years, and a tax assessment for the 2008 tax year. Morristown claimed the hospital was precluded from the tax exemption because the property was conducted for profit. Litigation commenced, and in 2010, the Tax Court determined that the property was owned by an entity organized exclusively for a tax-exempt purpose, and nearly all of the property was actually used for hospital purposes, therefore meeting the organization and use tests. However, the Tax Court ruled that leased office space and a café located in the hospital were conducted for profit, therefore violating the profit test, subjecting those areas of the hospital to the property tax. As for the rest of the property, the Tax Court determined that a genuine issue of material fact existed.
Following oral argument, the Tax Court reaffirmed its own initial ruling that the leased office space and café were for-profit ventures. In several orders issued in 2013 and 2014, the Tax Court again held that the organization and use tests were satisfied, with the exception of the hospital's gift shop. The final issue before the Tax Court in this matter was whether the remaining areas of the property were conducted for profit.
Tax Court Addresses Profit Test
In its final decision, the Tax Court ultimately determined that with the exception of the hospital's auditorium, fitness center and the visitors' garage, the hospital's property tax exemption claim was denied because it did not satisfy the profit test. In doing so, the Tax Court went into voluminous detail into how to determine whether the operation and use of property were for profit for the various areas of the hospital. The Court focused predominantly on the various types of physicians employed by the hospital, the salaries paid to its employees and executives, and whether it was possible to discern and delineate between the for-profit and non-profit activities of the hospital.
With respect to the various types of physicians employed at the hospital, the Tax Court identified employed physicians, voluntary physicians, and exclusive contract physicians as the three relevant classes of physicians to consider. Employed physicians were selected by the hospital based on "community need" with respect to certain fields of medicine. Voluntary physicians were considered to be private, for profit, self-employed physicians practicing in the community, with privileges to treat patients at the hospital. Likewise, exclusive contract physicians which provided medical services in various specialty fields throughout the hospital operated on a private, for-profit basis. The hospital had no restrictions or limitations with respect to where all three categories of physicians practiced. Moreover, employed, voluntary, and exclusive contract physicians operated throughout the entire property including the hospital. The Tax Court noted that under prior precedent, an organization claiming exemption could have both exempt and non-exempt uses on its property as long as the two purposes could be separated and identified, with the non-exempt use not being eligible for the property tax exemption.4 Generally, the Tax Court could not separate and identify the exempt and non-exempt uses of the property, in part based on the lack of restriction on where the for-profit and not-for-profit physicians worked, and denied the hospital's exemption request for most of the areas of the hospital.
In analyzing the profit test, The Tax Court also considered the benefits flowing from the hospital to related and unrelated for-profit entities. The hospital engaged in significant loans and other financial dealings with private physician practices, related captive insurance companies, and unrelated companies. The Tax Court concluded that this activity served to entangle the hospital's activities and operations with for profit-entities, and allowed the property to be used for profit.
With respect to its focus on hospital executive salaries, the Tax Court conducted an analysis to determine if such salaries were excessive, and indicative of a for-profit enterprise. In doing so, the Tax Court considered whether the salaries were comparable to other salaries paid by similar institutions. In determining that the salaries were excessive, the Court relied on the "incentive component" of the employed physicians' contracts. The Court concluded incentive components were "derived from departmental expenses and the profit was split between the hospital and the employed physicians," therefore indicating a profit-making purpose. The Court determined this incentive provision of the employed physicians' contracts violated the profit test.
The Tax Court then looked to agreements between the hospital and third parties to provide support services on the property to determine which support services could be considered not-for-profit, potentially allowing for a partial property tax exemption. The Tax Court determined that the visitors' parking garage was exempt from property tax as the financial arrangement between the hospital and the operator of the garage consisted of a fixed management fee. In contrast, the Tax Court determined that the areas of the hospital in which a support services company provided food and nutrition services, catering, environmental services, laundry and linen distribution, patient transportation, and plant operations maintenance was not exempt because the financial arrangement between the two parties was based in part on cost savings and constituted profit-sharing. The Tax Court also determined that the property on which the hospital's gift shop was located was not exempt because it did not satisfy the use test. According to the Tax Court, the gift shop did not serve a "core hospital purpose" and was simply a convenience for hospital visitors. Finally, the Tax Court found that the hospital's auditorium and fitness center qualified as exempt property, while the day care area and cafeteria were not exempt.
Commentary
New Jersey and many other states employ similar standards with respect to whether a charitable organization is exempt from property taxes. As made clear by the Tax Court's decision, the Paper Mill Playhouse three-part test to determining whether or not a charitable organization is entitled to an exemption from property tax retains its vitality, particularly the profit test. Based on this decision, it is relatively clear that New Jersey courts will not hesitate to heavily scrutinize a charitable organization's operation and use of its subject property.
Following the Tax Court's published decision, near the end of 2015, the hospital and the town of Morristown settled this matter for the 2006 through 2015 assessment years prior to further litigation. Pursuant to the settlement, the hospital will pay approximately $15.5 million to Morristown over a ten-year period, consisting of approximately $5.5 million in penalties and interest, as well as an annual tax payment of over $1 million representing an assessment on about 24 percent of the hospital property.5
On January 11, 2016, the New Jersey legislature passed legislation concerning the property tax exemption for certain nonprofit hospitals.6 However, Governor Chris Christie pocket vetoed the legislation by allowing it to expire unsigned at the conclusion of the legislative session. The bill, if enacted, would have maintained property tax exemptions for nonprofit hospitals that had on-site, for-profit medical providers. In addition, the bill required such hospitals to pay community service contributions to the local municipality, established a Nonprofit Hospital Community Service Contribution Study Commission, and prohibited the assessment of a nonprofit hospital as an omitted property for tax years 2014 and 2015.7 In response, on March 18, 2016, Governor Christie announced the formation of a new Property Tax Exemption Study Commission in conjunction with a two-year freeze on property tax assessments for previously exempt hospitals.8 This action is intended to provide the state with the information and time necessary to develop the proper solution for the property tax exemption for nonprofit hospitals. Legislation for these initiatives will need to be passed by the legislature and approved by Governor Christie.
Courts in other states recently have evaluated these issues. In 2012, the Pennsylvania Supreme Court considered the property tax exemption for a purely public charity.9 To be considered a "purely public charity" in Pennsylvania for purposes of tax-exempt status, all institutions must satisfy the five-part definition under Article VIII, Section 2 of the Pennsylvania Constitution (commonly known as the HUP test).10 In 1997, Pennsylvania enacted legislation, the Institutions of Purely Public Charity Act, which provides a more lenient test (commonly known as the Act 55 test) for determining whether an institution is a purely public charity.11 In this case, the institution argued that it was not required to meet the HUP test if it satisfied the Act 55 test. The Court disagreed and held that institutions must continue to satisfy the more stringent HUP test.
In 2010, a majority of the Illinois Supreme Court held that a religiously-affiliated Illinois hospital was not entitled to an exemption from property tax because it failed to establish that it was a charitable institution.12 In addition, a plurality of the Court determined that the hospital failed to demonstrate that its property was actually exclusively used for charitable purposes. This decision raised questions about what sufficiently constitutes charitable use for property owned by charitable institutions, especially hospitals, in Illinois. In response to this decision, in 2012, Illinois enacted legislation creating a new category of charitable exemption for hospitals.13 The Illinois Appellate Court recently held that this statutory exemption for hospital property based on the value of the charitable services the hospital provided was unconstitutional.14 Specifically, the Court found that the exemption violated constitutional language limiting the available property tax exemption to property used exclusively for charitable purposes.
As discussed above, the standards for determining whether property owned by a nonprofit entity is eligible for a tax exemption are similar between many states, but there are intricacies in many jurisdictions and the standards sometimes are difficult to apply. Nonprofit entities attempting to obtain a property tax exemption in jurisdictions that strictly scrutinize the entities' nonprofit use of the property may have planning options to consider. For example, in an effort to preserve a portion of a property tax exemption, the entity may wish to isolate its nonprofit activity and employees performing this activity in a separate subsidiary. If imbued with proper business purpose and economic substance, this type of restructuring could be used as a means to ensure that a company's nonprofit activities are distinct from other activities that are conducted for profit. Of course, this type of planning requires consideration of how such a restructuring could impact the company from an overall tax and business perspective.
Footnotes
1 AHS Hospital Corp. v. Town of Morristown, New Jersey Tax Court, Nos. 010900-2007, 010901-2007, 000406-2008, June 25, 2015.
2 N.J. REV. STAT. § 54:4-3.6, which states in relevant part, "The following shall be exempt from taxation under this chapter . . . all buildings actually used in the work of associations and corporations organized for hospital purposes, provided that if any portion of a building used for hospital purposes is leased to profit-making organizations or otherwise used for purposes which are not themselves exempt from taxation, that portion shall be subject to taxation and the remaining portion only shall be exempt . . . provided, in case of all the foregoing, the buildings, or the lands on which they stand, or the associations, corporations or institutions using and occupying them as aforesaid, are not conducted for profit . . .. The foregoing exemption shall apply only where the association, corporation or institution claiming the exemption owns the property in question and is incorporated or organized under the laws of this State and authorized to carry out the purposes on account of which the exemption is claimed . . .."
3 472 A.2d 517 (N.J. 1984).
4 International Schools Services, Inc. v. West Windsor Township, 21 A.3d 1166 (N.J. 2011).
5 As reported by Tim Darragh, NJ.com, "Atlantic Health to Pay Morristown $15.5M to Settle Tax Case," Nov. 10, 2015; As reported by Tim Darragh, NJ.com, "Atlantic Health to Pay Morristown $15.5M to Settle Tax Case," Nov. 10, 2015; http://www.nj.com/morris/index.ssf/2015/11/atlantic_health_to_pay_morristown_155m_to_settle_t.html.
6 S.B. 3299.
7 Id.
8 Press Release, Office of New Jersey Governor Chris Christie, March 18, 2016.
9 Mesivtah Eitz Chaim of Bobov, Inc. v. Pike County Board of Assessment Appeals, 44 A.3d 3 (Pa. 2012).
10 This test derives its name from Hospital Utilization Project v. Commonwealth, 487 A.2d 1306 (Pa. 1985). Under this test, an institution qualifies as a "purely public charity" if it: (i) advances a charitable purpose; (ii) donates or renders gratuitously a substantial portion of its services; (iii) benefits a substantial and indefinite class of persons who are legitimate subjects of charity; (iv) relieves the government of some of its burden; and (v) operates entirely free from private profit motive.
11 10 PA. STAT. ANN. §§ 371-385. This provides institutions with a more favorable standard for meeting the "relieving government of some of its burden" test.
12 Provena Covenant Medical Ctr. v. Department of Revenue, 925 N.E.2d 1131 (Ill. 2010).
13 P.A. 97-688 (S.B. 2194), Laws 2012, enacting 35 ILL. COMP. STAT. 200/15-86.
14 Carle Foundation v. Cunningham Township, Appellate Court of Illinois, Fourth District, Nos. 4-14- 0795, 4-14-0845, Jan. 5, 2016. For a discussion of this case, see GT SALT Alert: Illinois Appellate Court Finds Hospital Property Tax Exemption Unconstitutional.
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