On Remand from Eighth Circuit, Mayo Clinic Wins $11 Million UBIT Refund

(Parker Tax Publishing December 2022)

On remand from the Eighth Circuit, a district court held that the Mayo Clinic (Mayo) qualified as an educational organization under Code Sec. 170(b)(1)(A)(ii) because it is organized and operated exclusively for educational purposes and has no substantial noneducational purpose. The court therefore held that Mayo was entitled to a refund of the unrelated business income tax it paid on certain investment income it received. Mayo Clinic v. U.S., 2022 PTC 368 (D. Minn. 2022).

Background

Mayo Clinic (Mayo), a Minnesota nonprofit corporation, oversees healthcare system subsidiaries and operates the Mayo Clinic College of Medicine and Science. Mayo is a Code Sec. 501(c)(3) tax-exempt organization. After an audit in 2009, the IRS concluded that Mayo owed unrelated business income tax (UBIT) on certain investment income it received from the investment pool it manages for its subsidiaries. According to the IRS, Mayo was not a "qualified organization" exempted from paying UBIT on unrelated debt-financed income under Code Sec. 514(c)(9)(C)(i). Qualified organizations include an organization described in Code Sec. 170(b)(1)(A)(ii). That section describes "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 IRS determined that Mayo did not meet the requirements of Reg. Sec. 1.170A-9(c)(1), which provides a definition of an educational organization described in Code Sec. 170(b)(1)(A)(ii). Under Reg. Sec. 1.170A-9(c)(1), an educational organization is described in Code Sec. 170(b)(1)(A)(ii) "if its primary function is the presentation of formal instruction and it 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....It does not include organizations engaged in both educational and noneducational activities unless the latter are merely incidental to the educational activities."

Mayo paid the tax and brought a refund action in a district court. In Mayo Clinic v. U.S., 2019 PTC 295 (D. Minn. 2019), the district court held that Reg. Sec. 1.170A-9(c)(1) is invalid because it adds requirements -- the "primary function" and "merely incidental" tests - that Congress did not intend to include in the statute. The government appealed to the Eighth Circuit which, in 2021 PTC 132 (8th Cir. 2021), reversed the district court and held that Reg. Sec. 1.170A-9(c)(1) is valid, but only in part. According to the Eighth Circuit, the terms "primary function" and "merely incidental" in Reg. Sec. 1.170A-9(c)(1) have a valid role in interpreting the statute. However, the Eighth Circuit held that the "formal instruction" was invalid because a tax exempt educational purpose need not include the presentation of formal instruction. With regard to Mayo, the Eighth Circuit stated that the issue was whether its overall purpose and operations established that it was organized and operated exclusively for educational purposes. The Eighth Circuit remanded the case to the district court to make this determination.

Analysis

The district court held that during the years at issue, Mayo was organized and operated exclusively for an educational purpose and had no noneducational purpose that was substantial. The district court held that, therefore, Mayo was entitled to a refund of the UBIT it paid for the years at issue.

The district court noted that Mayo was founded by Dr. Charles Mayo and his brother, Dr. William Mayo (Mayo Brothers) in 1919 when they executed a Deed of Gift, which transferred all of the assets related to their clinical practice to the Mayo Properties Association. The purpose of the gift was to facilitate education and research and to provide quality medical education. The court noted that the Deed of Gift was incorporated into Mayo's governance documents during the years at issue and required that Mayo's assets be transferred to a medical school if the requirements of the Deed of Gift could not be met. The court reasoned that such a transfer has never occurred because Mayo has consistently maintained its educational purpose over time. In addition, the court determined that Mayo's articles of incorporation, its bylaws, its governance documents, and its mission statement reflect its substantial educational purposes.

The court further found that Mayo's educational purposes are also reflected in its day-to-day operations. In the court's view, from the highest levels of its corporate governance to its daily operations, education is at the heart of what Mayo does every day. The court noted that Mayo operates five accredited schools. The vast majority of physicians at Mayo, the court noted, hold faculty appointments, thus demonstrating that they are not mere health care providers but educate through health care. The court said that the facilities at Mayo are predominantly used for educational purposes, and the medical treatment and research at Mayo nearly always serves an educational purpose - even when involving students in the treatment and research renders health care more expensive. Mayo's finances also illustrated to the court that education is a substantial purpose of the organization. The court observed that each year, Mayo conducted its educational activities at a loss and spent at least 11 percent of its endowment on such activities.

The court said that it was unconvinced that Mayo's revenue relating to patient care showed that education was not a substantial purpose of the organization. The court pointed out that the net income from patient care was not sufficient to cover the costs of education and research and reasoned that if Mayo's operations were focused on making a profit, it likely would not qualify as a Code Sec. 501(c)(3) organization at all. The court noted that the government had conceded that Mayo met the faculty, curriculum, students, and place requirements of Code Sec. 170(b)(1)(A)(ii) and said this too suggested substantial educational purposes, as an organization that did not have a substantial educational function would likely not go to the trouble of maintaining a faculty and regular body of students, let alone providing a meeting place for them and a regular curriculum.

The court also found that Mayo's patient care and research activities were not substantial, non-incidental activities in noneducational areas. According to the court, while patient care was certainly substantial, it was not noneducational at Mayo, considering that Mayo integrated education and clinical practice. The court also found that Mayo's ownership of the Mayo Clinic Health System, a group of hospitals and clinics located within a 200-mile radius of Rochester, Minnesota, served Mayo's educational purpose by enlarging Mayo's patient population and catchment area. In addition, the court concluded that Mayo's research functions were exclusively educational. The court reasoned that, much like any university's research, Mayo's research was designed to improve both knowledge and outcomes for patients. However, the court concluded that Mayo's research was also critical part of the education of many of its students and trainees.

Finally, the court addressed the government's argument that expenditures such as maintaining physical facilities, human resources, and other such administrative tasks, disqualified Mayo from the UBIT exemption. Mayo's administrative functions, the court determined, were neither substantial nor noneducational. The court pointed out that Mayo's administrative services expenses were 3.4 percent of Mayo's total system-wide expenses, and such services supported Mayo's educational purpose since administration is never conducted for its own sake. No company exists, the court said, only so that its human resources department, for example, can thrive. Instead, such functions necessarily serve an organization's purposes and administration is therefore necessarily incidental to educational purposes if it supports those educational services.

For a discussion of Code Sec. 501(c)(3) organizations, see Parker Tax ¶60,502. For a discussion of UBIT and unrelated business taxable income, see Parker Tax ¶66,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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