A New Source of Revenues for Cash-Strapped Municipalities

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The local property tax exemption for non-profit institutions has come under attack in recent years, as municipalities, coping with diminishing tax bases, have sought new sources of revenue to bolster their treasuries, especially as their pension and OPEB obligations loom large.

Periodically, federal legislators revisit the rationale for allowing not-for-profit hospitals to retain their federal tax exemption. So far, the exemption has remained. Federal tax exemption for hospitals has generally focused on whether health care providers are fulfilling their obligations to provide charity care and community benefits. The IRS form 990 requires hospitals to delineate these amounts, but there is no one standard that quantifies an acceptable amount. IRS permits hospitals broad discretion in calculating community benefit which includes the value of free care or discounted care to those who are unable to pay and the difference between the Medicaid reimbursement rate and the actual cost of care.  Community benefit also includes community health services, health fairs, operating some research labs and allowing executives time off to serve on local community boards.

In 2013, a study conducted by The New England Journal of Medicine reported that, based on IRS filings beginning in 2009, hospitals spent an average of 7.5% of their operating expenses on charity care and community benefit.  The amount of spending ranged a low of less than 1% to a high of 20 percent.  Under the Affordable Care Act, federal tax exemption will be revisited every three years, depending upon the amount of community benefit a hospital provides. With more patients able to obtain insurance under the ACA, retaining tax exempt status will become more challenging for non-profit hospitals, especially those located in Medicaid expansion states.

More recently, tax exemption at all levels for hospitals has come under attack as a result of the corporate integration of hospitals, physicians, insurance companies, durable medical equipment providers and other activities that have been subsumed under hospitals’ corporate umbrellas. Other practices raising red flags have been aggressive collection policies and the payment of high salaries to hospital executives.  In the capital finance arena, bond counsel have been careful to segregate property used for proprietary activities from tax exempt uses in structuring tax exempt versus taxable bonds.  If both activities will occur in the same building, the costs are generally allocated on a square footage basis.

Case law on the subject of property tax exemption has been evolving in interesting directions and hospital legal counsel should take careful notice.

In 2010, in a case that dates back to 2003, The Illinois Supreme Court upheld a 2008 Appellate Court ruling that an Illinois Hospital, Provena Covenant Medical Center, failed to demonstrate the amount of charity necessary to qualify for a property tax exemption, obligating it to pay $1.2 million per year in local property taxes.  Since that time, the Illinois Department of Revenue has denied property tax exemptions to other hospitals in the state.

Earlier this year, a New Jersey Tax Court issued a far-reaching opinion in its finding that 700 bed Morristown Memorial Hospital, a subsidiary of Atlantic Health System, was obligated to pay property taxes, ranging from $2.5 million to $3.0 million, for tax years 2006 through 2008, with some small property exceptions. Previous rulings on property tax exemptions have focused on charitable contributions and community benefit in determining whether or not a hospital was exempt.

In New Jersey, however, the exemption test goes to corporate structure and property use and is tied to three tenets:

  • The property must be owned by an organization organized exclusively for tax exempt purposes
  • The property itself cannot be used for any for-profit use, “The Use Test”
  • The operation of the property must be conducted for not-for-profit uses, “The Profit Test”

The Morristown decision concentrated on The Profit Test, concluding that the hospital was not able to prove that the use of most of its property was for non-profit activities.  Below is a summary of the Court’s rationale for its decision:

  1. Working capital loans were provided to its for-profit physician practices from profitable areas of the hospital
  2. Recruitment loans were provided to new physicians which were later forgiven and then declared as physician income
  3. Interest-free loans were provided to certain parent subsidiaries to purchase equipment and other items
  4. Some executives performed multiple roles as executives and board members within the System
  5. The Hospital paid for insurance for itself and other members of the System and loaned funds to a System insurance subsidiary and guaranteed a line of credit for this subsidiary
  6. The Hospital also loaned funds to non-affiliated for-profit physician groups and related entities with some interest-free repayment terms
  7. The executive compensation was excessive
  8. Employed physician contracts violated the Profit Test
  9. The Hospital’s gift shop violated the Use Test because it fails to provide a medical purpose

It is expected that this ruling will have nationwide repercussions for other hospitals.  Property tax exemption questions have arisen in many cities in which large academic medical centers own significant amounts of property that are often excluded from the tax rolls, including Cleveland, Pittsburgh and Baltimore,.  While some hospitals have agreed to PILOT assessments, also known as  “Payments in Lieu of Taxes," municipalities must walk a fine line between imposing levies that cover the cost of fire, police and sanitary sewer services and causing financial harm that will lead hospitals, often the area’s largest employers, to curtail needed community services.
Clearly, this is another evolving credit factor on which muni analysts need to focus, with obvious implications for similar sectors, such as Higher Education.

Shelley Michelson is a director at New Oak Capital and
welcomes comments and feedback at: smichelson@newoak.com

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