The New Jersey Tax Court’s decision in AHS Hosp. Corp. v. Town of Morristown, DOCKET Numbers.: 010900-2007, 010901-2007, 000406-2008 (Decided June 25, 2015), has triggered widespread concern among hospital enterprises and other non-profit entities benefiting from property tax exemptions. The issue in the case was whether Morristown Memorial Hospital (MMH) should benefit from the New Jersey real property tax exemption for non-profit organizations. The town of Morristown contended that MMH’s use of the property did not fit the definition of tax exempt activities under N.J.S.A. 54:4-3.6, which provides an exemption from real property tax for:
all buildings actually used in the work of associations and corporations organized exclusively 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 … . (emphasis added).
The court embarked on a lengthy discussion of the history of hospitals in the United States, which concluded that hospitals largely have evolved from eleemosynary institutions for the poor that were by definition charitable into fee based profit-making enterprises bearing little resemblance to their predecessors. The court then reviewed the statute under existing precedent, and delved into whether three criteria were satisfied:
(1) [the owner of the property] must be organized exclusively for the [exempt purpose]; (2) its property must be actually and exclusively used for the tax-exempt purpose; and (3) its operation and use of its property must not be conducted for profit.
(citations omitted). The court held that in and of itself, an exempt purpose (i.e. operation of a hospital) is not sufficient to support an exemption. The entity also must demonstrate that the property for which the exemption is granted is “exclusively used for the exempt purpose” and does not undertake “for profit” activities.
Application to MMH
Applying the three part test to MMH, the court focused on (a) the relationship between MMH and the physicians working on the hospital property, (b) how those physicians were physically present on the property, and (c) the relationship of MMH with for profit activities.
The court recognized that three types of physicians work at MMH. First, there are “employed” physicians who work directly for the hospital treating all patients. Second, there are “voluntary” physicians who are engaged in private for profit practice but have privileges to treat their patients in the hospital. Third, there are physicians with exclusive contracts with the hospital to provide services, including radiology, anesthesiology, and pathology functions, referred to as RAP physicians. The court noted that voluntary and RAP physicians’ services are billed to patients separately from the hospital’s nursing and support fees. The court viewed the services of voluntary and RAP physicians as for profit activities by private doctors, not non-profit hospital activities.
The court then examined how the voluntary and RAP physicians function within the hospital environment, noting that “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.” However, at MMH “[p]hysicians actually are allowed anywhere in the hospital . . . they do their work everywhere.” The court thus concluded that it was “unable to discern between the non-profit activities carried out by [MMH at the hospital property], and the for-profit activities carried out by private physicians.”
The court finally turned to the third prong, whether MMH was conducting activity for profit. The court noted that MMH loaned funds and provided guarantees for the benefit of its for-profit affiliates. Some of these were granted without interest and others were forgiven at later points in time and treated as compensation to physicians. Hospital employees also worked at one for profit surgical facility and provided the staffing for an affiliated insurance entity’s risk management department. These activities were held to constitute a “commingling of effort and activities with for-profit entities … .” The fact that the same individual served as the Vice President of MMH and as the sole decision-maker for the various entities let the court to characterize an arm’s length relationship among the entities as “impossible”.
The court also examined executive and physician compensation. The hospital’s President and CEO received compensation in excess of $5 million in 2005 (the court also noted the compensation of other key executives). The court concluded that MMH had the burden of showing that the salaries were not excessive and that “it failed to … establish reasonableness of the compensation … .” The court complained that evidence was not introduced to support that the salaries used as comparables were from similar institutions. The court also determined that the incentive compensation structure for physicians demonstrated a “profit making purpose” because it is based on revenues. The court concluded that MMH was engaged in activity for profit and therefore failed the third part of the test.
Applicability of the AHS Analysis to New York Hospitals
On its face, the applicable New York statute, Real Property Tax Law §420-a 1, is more permissive of granting tax exemptions to hospitals. It provides in relevant part that:
(a) Real property owned by a corporation or association organized or conducted exclusively for … hospital … purposes … and used exclusively for carrying out thereupon … such purposes either by the owning corporation or association or by another such corporation or association as hereinafter provided shall be exempt from taxation as provided in this section.
(b) Real property such as specified in paragraph (a) of this subdivision shall not be exempt if any officer, member or employee of the owning corporation or association shall receive or may be lawfully entitled to receive any pecuniary profit from the operations thereof, except reasonable compensation for services in effecting one or more of such purposes, or as proper beneficiaries of its strictly charitable purposes; or if the organization thereof for any such avowed purposes be a guise or pretense for directly or indirectly making any other pecuniary profit for such corporation or association or for any of its members or employees; or if it be not in good faith organized or conducted exclusively for one or more of such purposes.
Thus, in 1962, the Court of Appeals held in St. Luke's Hospital v. Boyland, 237 N.Y.S.2d 308, that in the case of a hospital that is not a free public hospital, “total exemption is accorded only if the building is used exclusively for carrying out … hospital purposes, except that proportionate partial exemption is allowed to the extent that a portion only of any lot or building of any such corporation or association is used exclusively for carrying out … hospital purposes.” The question of what activities constitute “hospital purposes” is a determinative factor in deciding whether exemption will be upheld.
In 1975, the Appellate Division, Fourth Department, held in Genesee Hosp. v. Wagner, 364 N.Y.S. 2d 934, that an office building adjacent to a hospital was exempt. The hospital leased suites to physicians who conducted their private practices in the suites. The court held that where the property was used for hospital purposes, that portion of the property would have been entitled to a tax exemption. The Appellate Division examined whether the use was “in furtherance of the permitted purposes.” The Fourth Department revisited its analysis in 2011, in Matter of Viahealth of Wayne v. VanPatten, 936 N.Y.S. 2d 466. where it held that property leased to other non-profit corporations that provided ancillary X-ray and laboratory services would qualify for tax exemption. However, areas leased to other non- profit enterprises could not be exempt unless they primarily furthered the purposes of the hospital. More recently, in March, 2015, the Fourth Department noted that “the private practice of medicine by a hospital's attending physicians is primarily a commercial enterprise, and such physicians’ offices are not entitled to a tax exemption. Matter of Crouse Health Sys., Inc. v City of Syracuse, 2015 NY Slip Op. 02258 (Decided; March 20, 2015). (emphasis added).
New Jersey and New York are among a number of states where municipalities, struggling to find needed funds, are looking for ways to raise revenue. The AHS decision is particularly damaging to claims for property tax exemption. It remains to be seen whether appellate review or legislative action will alter the decision. While the New York statute appears more advantageous for hospitals, Crouse Health seems to open the door to the distinction between hospital activity and the commercial private practice of medicine. It thus behooves hospitals to review how their real estate is used and, to the greatest extent possible, be prepared to demonstrate what portion of a property is used exclusively by the hospital and what portions are used by physicians engaged in private practice. Undoubtedly, the question of what constitutes for profit activity is going to become a prevalent aspect of tax exemption cases. Hospitals must clearly separate traditional hospital activities from those that may be more akin to profit making enterprises and take care to ensure that there is no commingling of assets. Furthermore, hostpitals will need to be prepared with a thorough analysis to support that executive compensation is not excessive and that physician compensation is linked to measurements that will not be characterized as demonstrating a "profit-making purpose."