The Tax Court of New Jersey decided AHS Hospital Corp. v. Town of Morristown, a case of first impression with potentially serious consequences for nonprofit hospitals seeking to qualify under N.J.S.A. 54:4-3.6, a statutory property tax exemption applicable to “[a]ll buildings actually used for . . . hospital purposes.”  The court held, on June 25, 2015, that AHS Hospital Corp. (the Hospital), and in ominous dicta perhaps all modern nonprofit hospitals in New Jersey, fail to qualify for the property tax exemption under the state statute.

Background of the Decision

The Hospital, a nonprofit New Jersey corporation, challenged the denial of its claims for property tax exemption for certain tax years pursuant to N.J.S.A. 54:4-3.6.  Hospitals seeking to qualify under the statute bear the burden of satisfying a three-part test adopted by the New Jersey Tax Court: (1) the owner of the property must be organized exclusively for the exempt purpose; (2) the property must be actually and exclusively used for the tax-exempt purpose; and (3) the operation and use of the property must not be conducted for-profit.  Analysis of the third prong (the Profits Test), according to the court, involves a pragmatic inquiry into profitability, requiring a realistic common-sense analysis of the actual operation of the taxpayer. Of critical importance to the court is “where the profit goes.”  If it can be traced to “someone’s personal pocket,” the taxpayer will not be entitled to the exception.  Prior New Jersey jurisprudence established that excessive salaries and third-party contracts entered into for a profit-making purpose fail to satisfy the third prong. When for-profit and nonprofit uses of the property are sufficiently comingled, the exemption will not apply. The court had previously determined that the Hospital had satisfied the first two prongs for nearly all aspects of the property, leaving only the Profits Test to be evaluated.

The Court’s Analysis of the Profits Test

The court determined that the Hospital failed to satisfy the Profits Test based on a number of factors related to the Hospital’s organization and operation.  First, the court noted that private, self-employed, for-profit physicians were eligible to hold leadership positions within the Hospital, use the same Hospital facilities as Hospital-employed physicians and were able to operate in all areas of the property. Given these findings, the court determined that the private physicians’ for-profit uses of the property were commingled with the property’s nonprofit uses, failing the Profits Test.

Second, the court considered the corporate structure and operations of the Hospital.  The parent entity of the Hospital owned a number of additional for-profit and nonprofit subsidiaries. The Hospital itself owned several for-profit physician practices and provided Hospital employees to assist in their operation. The Hospital provided substantial subsidies to these affiliated entities in the form of working capital loans, capital loans and recruitment loans. The boards of these various entities were largely composed of the same individuals, precluding the possibility of the Hospital engaging in transactions with these affiliates at an arm’s-length basis. In light of these findings,  the court held that the Hospital commingled its activities with for-profit entities, failing the Profits Test and precluding exemption.

Third, the court considered whether Hospital physician and executive compensation satisfied the Profits Test.  The Hospital’s employment agreements with employed physicians provided for both a standard salary and a revenue-sharing structure, dividing the revenues between the hospital and the employed physicians. The court held that the revenue splitting portions of the employment contracts demonstrated a profit-making purpose, failing the Profits Test. With respect to executive compensation, the Hospital maintained that compensation paid was reasonable pursuant to standards established by the Internal Revenue Service. The court rejected the application of the IRS standard, noting instead that the court must determine whether the compensation paid to executives is comparable to compensation paid to similar positions for similar work by entities of a similar nature, size and location as the Hospital. The court found expert testimony unpersuasive regarding the reasonableness of Hospital executive compensation. The Hospital’s expert witness testified that the New York metropolitan area was selected by the Hospital’s compensation committee as the best peer group for setting Hospital compensation given that the Hospital competed for talent with organizations located in this area and was located within the greater New York metropolitan area. The court found this testimony unpersuasive, noting that no evidence was provided by the expert to support these conclusions.  

As the burden rests with the entity seeking to take advantage of the exemption, the court held that the Hospital failed to satisfy the Profits Test with respect to executive compensation. It is interesting to note that the IRS standard identified by the court is one of the required elements of the rebuttable presumption procedures set forth in Section 4958 of the Internal Revenue Code and does require that an independent governing body consider comparable salary and benefits data.

Finally, the court examined various third-party agreements entered into by the Hospital,  including contracts for the maintenance of the visitor parking garage, the provision of patient transportation services and food catering services, among others.  The contract for the maintenance of the visitor parking garage contained a fixed management fee, required the Hospital to pay the expenses of operating the garage and did not pay excessive fees to the maintenance company or its employees. The court held that this contract satisfied the Profits Test. The remaining third-party contracts contained provisions for splitting reduced expenses between the Hospital and the relevant third party. The court held that these provisions constituted revenue splitting and failed the Profits Test, rendering areas of the property connected with those services not available for property tax exemption. The Hospital’s gift shop also did not satisfy the Profits Test as it did not qualify as “a core hospital purpose” and was not reasonably necessary for a hospital purpose.

 After considering all of the information, the only areas of the Hospital property that satisfied the Profits Test and therefore qualified for the exemption were the visitors parking garage, the Hospital auditorium—as there was no evidence payments were collected for its use— and the Hospital fitness center, as any profit received from this location was de minimis and the testimony of the parties indicated there was no considerable business purpose for the location. All other areas of the Hospital failed to satisfy the requirements for the exemption.

Implications for NJ’s Nonprofit Hospitals

This decision raises concerns over the continued property tax exemption of properties held by nonprofit hospitals operating in New Jersey.  In fact the court makes clear that  “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.”  It is too early to determine whether the Hospital will pursue an appeal of the decision, whether other New Jersey municipalities will attack the property tax exemption of hospitals located within their jurisdictions or whether legislative remedies may be required as suggested by the court.  Statutory property tax exemptions vary considerably among the states, reducing the likelihood that this case will carry substantial precedential weight in other jurisdictions. In New Jersey however, it is difficult to imagine a series? of facts that would allow a nonprofit hospital to qualify under the exemption going forward.   

© 2015 Perkins Coie LLP