A Cautionary Case for Tax-Exempt Hospitals

A New Jersey case denying a hospital a property-tax exemption is a wake-up call for not-for-profit hospitals around the country.
By Stephen D. Kirkland, CPA/CFF

A recent property tax case from the Tax Court of New Jersey should serve as a warning to tax-exempt medical centers and their tax advisers throughout the country. Although this case was specific to New Jersey, similar facts and laws exist in many other jurisdictions.

The town of Morristown, N.J., challenged the property tax exemption of Morristown Memorial Hospital. The court issued a lengthy opinion that explains in detail the multiple issues, facts, analyses, and conclusions in the case (AHS Hospital Corp. v. Town of Morristown, No. 010900-2007 (N.J. Tax Ct. 6/25/15)). The 88-page opinion includes a review of the history of tax exemptions for charitable organizations generally and hospitals in particular under English common law, U.S. federal tax law, and New Jersey and other state laws.

The court went to great lengths to describe the ways that not-for-profit hospitals have changed over the years. When the state laws exempting not-for-profit hospitals from taxation were drafted decades ago, most not-for-profit hospitals were “charitable alms houses providing free basic medical treatment to the infirm poor” (slip op. at 3). Today, hospitals have become sophisticated medical centers, providing a variety of medical and related services.

The court acknowledged that the Morristown hospital had “a well-deserved reputation for excellence in medical care and education” (slip op. at 4). However, the court explained that tax-exempt status is not based on the quality of care and the court would “not succumb to emotion.” Rather, the court determined that it must rely “on the sufficiency of the evidence and sound legal reasoning” in deciding whether the hospital, under its current method of operation, satisfied the criteria for property tax exemption (id.).

The court concluded that the hospital had the burden of proving it was entitled to a tax exemption and had failed to meet that burden on several grounds. The statute in question (N.J. Stat. §54:4-3.6) required (1) the property’s owner be organized exclusively for an exempt purpose; (2) the property to be actually and exclusively used for the exempt purpose; and (3) the hospital’s operation and use of its property not to be conducted for profit (slip op. at 40–41, citations omitted). Most of the hospital’s real estate did not qualify for property tax exemption even though the property was owned and used by a tax-exempt entity.

For-profit activities

The court closely examined what it meant for hospital activities to be conducted “for profit.” In this case, the hospital used its property to treat all patients regardless of their ability to pay. The court acknowledged that there is “no profit margin with respect to the treatment and care of Medicaid patients” (slip op. at 15). The court also acknowledged that the hospital operated programs that were “loss leaders.” For example, a pediatrician employed by a hospital may generate $100,000 in losses each year (slip op. at 16).

Although tax-exempt entities are not required to operate at a loss and are not prohibited from generating a profit, it is important to determine where the profit is going, the court said. A crucial factor was whether any of the profits could be traced “into someone’s personal pocket.” If so, the property would not be entitled to tax exemption (slip op. at 41).

In its defense, the hospital argued that the dominant motive for its activities was charitable. However, the court stated that an organization claiming exemption is permitted to have both exempt and nonexempt activities occurring on its property “so long as the two purposes can be separately stated and accounted for and so long as the non-exempt use is never subject to the property tax exemption” (slip op. at 45).  Accordingly, for-profit activities carried out on tax-exempt property must be “conducted so as to be evident, readily ascertainable, and separately accountable for taxing purposes” (id.). On the other hand, exemption will be denied where there is significant and substantial “com[m]ingling of effort and entanglement of activities and operations” on the property, regardless of whether the for-profit entities are related or unrelated to the not-for-profit organization (slip op. at 46).

Many modern tax-exempt hospitals, including the hospital in this case, are “intertwined with both non-profit and for-profit subsidiaries and unaffiliated corporate entities” (slip op. at 4, emphasis in original).

The court attempted to discern where the hospital’s not-for-profit activity ended and its for-profit activity began. Otherwise, to permit a not-for-profit entity to claim a property tax exemption when it has become inseparably entangled with for-profit entities would allow indirect taxpayer subsidization of the for-profit activities. In other words, a competitive advantage would be conferred on those for-profit entities at the expense of the taxpaying public. The court was unable to distinguish between not-for-profit activities carried out on the hospital’s property and the for-profit activities carried out by private physicians.

Three categories of physicians treated patients on the hospital’s property: employed physicians, voluntary physicians, and exclusive-contract physicians. Employed physicians had employment contracts and were on the hospital’s payroll. Voluntary physicians and exclusive-contract physicians are private-practice doctors who were allowed to treat patients at the hospital. Those two types of doctors operate on a for-profit basis. “Accordingly, the court must be able to determine where these physicians practice on the Subject Property in order to identify the areas of the Hospital that are subject to taxation” (slip op. at 47). That delineation was not possible in this case because the activities of the for-profit physicians were not contained within any particular area of the hospital. They operated throughout the hospital and used the hospital’s property to generate private medical bills that they charged directly to the patients. All the money those physicians billed went directly to them.

The hospital argued that because those fees were generated and retained by the for-profit physicians, the hospital did not profit from the physicians’ use of hospital property. The court stated that the issue is not just “the profitability of the tax-exempt entity that owns the property” (slip op. at 51) but also the doctors’ for-profit activities conducted on the property. In other words, the court believed that it must consider not only the financial benefits flowing to the entity claiming exemption but also benefits going to related and unrelated for-profit entities, including physicians.

Even though the entity claiming exemption may not have violated the profit test itself, the court felt that the hospital failed the profit test because the operation and use of the property was conducted for the benefit of other for-profit entities.

The fact that the hospital maintained relationships with a number of affiliated and nonaffiliated for-profit entities was also problematic. This included physician practices the hospital owned (captive PCs), which the hospital loaned millions of dollars to and subsidized when they lost money.

Recruitment loans were made directly to private physicians transitioning into the local community. Those loans were subject to forgiveness after a certain period of time. The physician practices did not have their own accounting departments; their financial and billing operations were processed by the hospital.

The hospital was affiliated with other for-profit entities, and certain executives and board members had roles in both the not-for-profit and for-profit entities. The court believed that it was “impossible for an arms-length transaction to occur under such circumstances” (slip op. at 61). Therefore, the court considered whether transactions between the entities were conducted at arm’s-length, such as the hospital’s guarantee of a $10 million line of credit and loans to these other entities, where in some cases, no interest rate was indicated.

One of the relationships most scrutinized was the hospital’s relationship with a self-insurance trust fund in the Cayman Islands. The fund did not process any insurance claims but simply operated as a bank account.

Even if all of these related-party transactions had been properly “charged back,” the court nonetheless concluded that there would be no meaningful separation between the for-profit and not-for-profit subsidiaries. In short, the hospital “called all the shots.”

As a result, the court found that the operation and use of the hospital’s property was conducted for a for-profit purpose and advanced the activities of for-profit entities. By entangling and commingling its activities with for-profit entities, the hospital allowed its property to be used for forbidden for-profit activities.

Executive compensation

The court also examined the salaries of hospital executives, which included rich benefits packages, and was not persuaded that the salaries were comparable to salaries paid for similar positions at similar institutions. Although the court acknowledged that not-for-profit entities were allowed to pay reasonable salaries for services actually performed, the hospital failed to meet its burden to establish the reasonableness of the compensation it paid.

New Jersey’s state law does not prescribe a method for determining comparable compensation, and the hospital had relied on federal law (Regs. Sec. 53.4958-6). The New Jersey court was not convinced that IRS regulations under federal income tax law should be relevant to New Jersey real property taxes, saying the hospital’s expert “provided no compelling reason why the court should employ the IRS standard other than it’s generally the only one out there” (slip op. at 70–71).

The hospital’s expert witness established a peer group of comparable hospital systems in the geographic area, but “he failed to show that the hospitals he chose for the peer group in fact did the same thing” by following a similar process (slip op. at 68). The court was not persuaded by the expert since he “offered no testimony or other evidence as to whether” the comparability “data was verified, accurate, reliable, or in fact, comparable” (id.). It was not known “whether the compensation committees of the peer group hospitals followed the same rigorous procedure” that the hospital’s expert had outlined. The court concluded that, if “the only consideration is what similar hospitals set as salaries, then the salaries would always be reasonable; a conclusion wholly self-serving to all non-profit hospitals” (slip op. at 69).

The court was not persuaded that the hospital’s compensation committee consisted of well-respected members of the board of directors, sophisticated business executives, and professionals, who understood the hospital, the health care industry, and the rules pertaining to executive compensation in the tax-exempt sector, because the record was “devoid of any evidence” of this expertise. The hospital expert’s claim that it had “to compete for talent with organizations in Manhattan, the rest of New York City, and its suburbs in New Jersey, New York and Connecticut” also did not persuade the court. Here again, the court said these conclusions were “unsupported by any evidence, testimony or reliable data for the court to evaluate” (slip op. at 69–70).

Compensation of employed physicians

Physicians employed directly by the hospital were paid a base salary plus an incentive. These amounts were based “very methodically on an assessment of the compensation for that specialty in the market area” (slip op. at 72). The incentive was paid based on qualitative factors, such as decreasing infections during a stay at the hospital, and quantitative factors such as the number of patient visits. The average incentive compensation amount paid to employed physicians was $32,000.

The hospital said it aimed to have base salaries for employed physicians at the 60th percentile of a peer group’s range as determined through national surveys. Once incentive compensation was added, total compensation was generally at about the 75th percentile of the range. Maximum total compensation was limited to the 90th percentile.

Although the compensation surveys had been obtained from reputable organizations, the court noted that there was no testimony about their credibility or reliability. In addition, the court noted that the hospital’s testimony claimed that it was common for hospitals to include incentive provisions in their physician employment contracts, but the hospital provided no evidence.

Incentive compensation was paid out of a portion of department revenues set aside for this purpose. The incentive pools were calculated in different ways among the departments, with many physicians receiving a percentage of their professional billings. Another format paid certain physicians a bonus from the net departmental revenues, with the remaining revenue going to the hospital.

In its analyses, the court acknowledged that not-for-profit organizations are permitted to pay salaries to their employees so long as the salaries “are not excessive, and they do not demonstrate a profit-making purpose” (slip op. at 75). However, the court believed there was a profit-making purpose in employment agreements “where revenues were divided between a hospital and its employed physicians” (id.). In this case, the revenue sharing showed that the employed physicians were given incentives that had been derived from departmental expenses. The profit was split between the hospital and the employed physicians, indicating that the operation was conducted for a profit-making purpose. Therefore, a portion of surplus revenues could be traced to “someone’s personal pocket” (slip op. at 76).

Third-party agreements

Hospitals often engage in contracts with third parties to provide certain services at the hospital. To satisfy the profit test, a hospital must prove that these contracts are not entered into with a “profit-making purpose.” The court examined the hospital’s management agreement with a private contractor that managed the visitors’ parking garage. Fixed fees paid were not excessive, and the garage operated at a loss. Therefore, the visitors’ parking garage was eligible for the property tax exemption.

The court then looked at another agreement the hospital had with a private contractor to provide food and nutrition services, laundry, transportation, and other services. This contract did not provide for a fixed management fee but instead split budgetary “savings.” This split was “profit-sharing disguised as cost-savings” (slip op. at 80), which showed a profit-making purpose typical of a “commercial activity or business venture” (slip op. at 81).

A gift shop within the hospital, run by the Women’s Auxiliary, did not qualify for the exemption. Although it generated a small profit, it did not qualify as a core hospital purpose since it did not provide “any medical service that a hospital patient may require pre-admission, during a hospital stay, or post-admission,” but  was merely a convenience for hospital visitors that competed with “commercially owned facilities” (slip op. at 84).


The court concluded that a not-for-profit organization that generates revenue in excess of expenses does not demonstrate, in itself, a profit-making purpose. However, “[i]f it is true that all non-profit hospitals operate like the Hospital in this case, as was the testimony here, then for purposes of the property tax exemption, modern non-profit hospitals are essentially legal fictions. . . . Accordingly, if the property tax exemption for modern non-profit hospitals is to exist at all in New Jersey going forward, then it is a function of the Legislature and not the courts to promulgate what the terms and conditions will be” (slip op. at 87–88).

As modern not-for-profit hospitals compete more and more with for-profit hospitals, and states and municipalities are hungry for revenue, hospitals and other not-for-profits will find their exemptions under attack. The New Jersey court looked to the state legislature to solve this problem by enacting laws to exempt these modern hospitals from property tax going forward if “a property tax exemption for modern non-profit hospitals is to exist at all”  (slip op. at 88).

Stephen D. Kirkland, CPA/CFF, serves as an expert witness in U.S. Tax Court cases involving (un)reasonable compensation issues. 

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