On June 25, 2015, a New Jersey Tax Court issued a significant opinion in the case of AHS Hospital Corp. d/b/a Morristown Memorial Hospital v. Town of Morristown, upholding the Town of Morristown’s denial of Morristown Memorial Hospital’s (the Hospital) property tax exemption for tax years 2006 through 2008 with only a few minor exceptions. The Hospital is a 700-bed, 1.1 million square foot facility providing a broad range of services to all patients regardless of ability to pay. Approximately eight percent of the Hospital’s patients are charity care patients.

Recent suits in other states examining the tax exemptions of non-profit hospitals considered charitable contributions as the primary factor in evaluating a hospital’s non-profit status. However, the court in Morristown delved into the inner workings and relationships of the Hospital, including its relationships with employed and non-employed physicians, relationships with its parent company, Atlantic Health Systems, Inc. (Atlantic), arrangements with other for-profit and non-profit subsidiaries in the Atlantic system, and arrangements with third-party vendors.

The following test established in New Jersey case law is used to determine whether a non-profit entity is entitled to a property tax exemption:

  1. The subject property must be owned by an entity organized exclusively for a tax-exempt purpose;
  2. The property must be actually and exclusively used for the tax-exempt purposes (the Use Test); and
  3. The operation and use of the property must not be conducted for-profit (the Profit Test).

The court’s decision in Morristown focused primarily on the “Profit Test,” finding that the Hospital failed to satisfy its burden of proof under the law to establish that its operation and use of the Hospital property was substantially for non-profit purposes. The decision was limited to the Hospital’s New Jersey state property tax exemption, and did not impact its federal non-profit tax status. However, as a result, the Hospital is responsible for back taxes in the amount of approximately $2.5 to $3 million per year. The facts and analyses underlying the court’s decision are summarized below.

Relationships with Affiliated and Non-Affiliated For-Profit Entities

In evaluating the Hospital’s activities under the Profit Test, the court closely scrutinized the Hospital’s relationship with affiliated and non-affiliated for-profit entities.

Atlantic is a fairly large and complex health system. The Hospital owns and operates two non-profit subsidiaries and six for-profit physician practice subsidiaries (the Physician Practices). Additionally, Atlantic owns and operates AHS Insurance Co., Ltd. (AHS Insurance), a single parent, captive for-profit self-insurance trust fund that insures the Hospital against professional and general liability, and Atlantic Health Management Corp. (AH Management), the owner and operator of for-profit imaging and surgical centers. Both AHS Insurance and AH Management are for-profit sister corporations of the Hospital.

Specifically, the court found that “by entangling its activities and operations with those of for-profit entities, the Hospital allowed its property to be used for-profit.” The court’s conclusion is based on the following Hospital activities:

  • The Hospital provided subsidies to its for-profit Physician Practices in the form of “working capital” or “capital” loans. In connection with these loans, the Hospital transferred money from profitable areas of the Hospital to subsidize these Physician Practices, which consistently operated at a loss.
  • The Hospital provided recruitment loans to private physicians to recruit them to the community; these loans were forgiven after a certain period, at which point the loan was declared income of the physician.
  • The Hospital issued interest-free loans to certain for-profit subsidiary entities of AH Management for the purchase of equipment and other items.
  • Certain executives, including the Chief Financial Officer and the General Counsel, served in dual roles as board members and executives for Atlantic, the Hospital, and other entities within the Atlantic system. The court suggested that these executives’ compensation was not properly allocated between the Atlantic entities.
  • The Hospital “entangled its activities and commingled its efforts” with AHS Insurance by (1) paying both the Hospital’s premiums and the premiums for other entities in the Atlantic system, (2) loaning money to AHS Insurance, and (3) guaranteeing a line of credit for AHS Insurance.
  • The Hospital also provided loans to non-affiliated, for-profit physician groups and related entities, some of which required the repayment of principal only.

Accordingly, the court found that the operation and use of the Hospital property at issue was conducted for a for-profit purpose and to advance the activities of for-profit entities failing the Profit Test.

Executive Salaries

The court also examined the salaries paid to the Hospital’s executives and the executives of Atlantic. These compensation structures included base salaries, incentive compensation, bonuses, and benefits packages that included perks such as automobile stipends, cell phone plans, and golf club memberships. The court noted that under New Jersey Supreme Court precedent, a tax-exempt organization is permitted to pay salaries to its staff as long as those salaries are not excessive, which is determined by comparing salaries paid by similar institutions, based on the nature, size, and location of the institution and the position for which the salary is paid.

The court concluded that the Hospital failed to establish the reasonableness of the compensation paid to its executives, despite the fact that the Hospital established a peer group of comparable hospital systems in the area, based on size, geographic location, purpose, revenue generation, and other factors. Its conclusion was based, somewhat confusingly, on the fact that the Hospital failed to demonstrate that the sample group of hospitals’ internal processes and methods for setting executive compensation were similar to the process used by the Hospital. The court also rebuffed the Hospital’s position that the court look to the IRS definition of reasonableness for non-profit tax exemption purposes, which the court conceded the Hospital satisfied with respect to executive compensation.

For-Profit Physician Services

Three types of physicians provided care at the Hospital: (1) employed physicians; (2) exclusively contracted physicians (radiologists, anesthesiologists, pathologists and emergency department physicians, collectively, RAP Physicians); and (3) “voluntary” (medical staff) physicians, who were private physicians seeing patients in the Hospital (Private Physicians).

During the years at issue, there were 1,200 Private Physicians with privileges providing professional services to their patients at the Hospital. Approximately 83 percent of the patients admitted to the Hospital were admitted by Private Physicians and RAP Physicians. The court recognized that the Hospital did not bill and collect for professional services provided by Private Physicians – the Hospital billed and collected for the technical component of services provided at the Hospital, while the Private Physicians separately billed and collected for the professional component of services provided to their patients receiving treatment at the Hospital’s campus. In evaluating the Hospital’s relationship with the Private Physicians, the court took the very aggressive position that because such physicians were generating a profit when providing services to Hospital patients, the entire Hospital campus was being used for for-profit activity. Accordingly, the court held that the Hospital failed the Profit Test.

Employed Physicians’ Contracts

The Hospital employed a small number of physicians in various departments. Although the employment contracts differed based on specialty and department, the Hospital used a number of common methodologies to calculate incentive compensation that was paid out of department incentive pools. The Hospital aimed to have base compensation for employed physicians at the 60th percentile of the peer group determined through national surveys, and at the 75th percentile with incentive bonuses taken into account. The Hospital capped the maximum total compensation for employed physicians at the 90th percentile.

Despite these standards, the court found that because the incentive pools were derived from departmental expenses and the profit was split between the Hospital and the employed physicians, the incentive compensation plans used by the Hospital demonstrated a profit-making purpose in violation of the Profit Test.

Third-Party Agreements

Finally, the court evaluated several vendor agreements, including (1) the Hospital’s parking garage management agreement; (2) the Hospital’s arrangement for food/nutrition services; catering, laundry, and linen services; patient transportation; and plant operations maintenance (Operations Agreement); and (3) the Hospital’s gift shop run by a charitable group.

Because the Hospital paid a fixed management fee and bore the expenses of operating the parking garage, the court found the garage management agreement did not violate the Profit Test. The court also noted the parking garage was operated at a loss to the Hospital. As a result, the parking garage would retain a property tax exemption.

The Operations Agreement differed from the parking garage arrangement in that the fee paid to the vendor included a 90 percent/10 percent split of budgetary savings, which the court characterized as either “incentive compensation or profit-sharing disguised as cost-savings.” As a result, the court concluded that the Operations Agreement evidenced a profit-making purpose.

The gift shop arrangement was evaluated by the court under the Use Test described above. The court found the gift shop failed to satisfy the Use Test because the gift shop does not provide any medical service that a hospital patient may require and, as a result, does not qualify as a “core hospital purpose.” Thus, the court concluded that the area occupied by the gift shop would be subject to property tax assessment.

Ultimately, the court found that only the Hospital’s auditorium, fitness center, and visitors’ garage were exempt from state property taxes. Although the decision only is binding precedent in New Jersey, the court’s aggressive analysis of common physician-hospital arrangements, the Hospital’s relationship with for-profit affiliates and other for-profit entities, the executive compensation issues, and the Hospital’s arrangements with third-party vendors merits consideration by all non-profit providers. Non-profit providers should be familiar with the standards in their states for maintaining property and other tax exemptions, particularly given the changing healthcare landscape in the aftermath of the Affordable Care Act and the move toward pay-for-performance reimbursement.