The Mayo Clinic is an “educational organization” entitled to tax-exempt treatment—contrary to the IRS’s position that the institution did not meet the agency’s requirements—because those requirements were more stringent than Congress intended.
Treasury regulations under tax code Section 170 require that to qualify as a tax-exempt “educational organization,” the organization’s “primary function” must be education and its noneducational activities “merely incidental” to its educational activities. A federal district court disagreed, finding that Congress didn’t include these requirements in the statute (Mayo Clinic v. United States, No. 16-cv-03113 (D. Minn. 8/6/19)).
Mayo Clinic is a Minnesota nonprofit corporation and tax-exempt organization under Section 501(c)(3). Mayo Clinic is the parent organization of several hospitals, clinics, and the Mayo Clinic College of Medicine and Science. The college, in turn, is comprised of five distinct medical schools that offer degrees and continuing medical education.
The IRS, after conducting an audit, asserted that Mayo Clinic owed tax on certain income it received from partnerships. The agency concluded that Mayo Clinic was not entitled to a tax exemption with respect to this income, because Mayo Clinic was not an “educational organization.” The IRS based this finding on the conclusion that Mayo Clinic’s ”primary function“ was not ”formal instruction.“
Unrelated Business Income
Tax-exempt charitable organizations under Section 501 are permitted to exclude from their “unrelated business income” (UBI) certain types of passive income. If, however, such passive income is earned using “leverage,” then the amount (of passive income) excluded from UBI is appropriately reduced. When the passive income emanates from debt-financed real property, however, the income can be excluded from UBI if, and only if, the organization under scrutiny constitutes a “qualified organization” under Section 514(c)(9)(C). Included among the qualified organizations is “an organization described in Section 170(b)(1)(A)(ii).”
An organization described in Section 170(b)(1)(A)(ii) is “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 pertinent regulation includes two (additional) requirements that do not appear explicitly in the statute. The regulation provides that: “An educational organization is described in Section 170(b)(1)(A)(ii) if its primary function is the presentation of formal instruction.…It does not include organizations engaged in both educational and noneducational activities unless the latter (activities) are merely incidental to the educational activities.”
The IRS did not dispute that Mayo Clinic, by virtue of its schools, satisfied the requirements relating to faculty, curriculum, students, and place. The government nonetheless argued that Mayo Clinic was not an education organization in light of the regulations.
Regulation Exceeds Statutory Authority
The regulation incorporated the primary-function and merely-incidental requirements, and these were the elements the IRS relied on for its position that Mayo Clinic was not an educational organization, the court said. The proper framing of the precise questions at issue, the court noted, is whether Section 170(b)(1)(A)(ii) “is silent or ambiguous with respect to the primary-function and merely-incidental requirements in the regulations.“ If the statute was so silent or ambiguous, then the regulation would almost certainly have been upheld. The statute, however, was neither.
Congress, the court concluded, unambiguously chose not to include a primary-function requirement in Section 170(b)(1)(A)(ii), and the Treasury Department exceeded the bounds of its statutory authority when it promulgated the primary-function requirement in RegulationsSection 1.170A-(9)(c)(1). Section 170(b)(1)(A)(ii) contains no explicit primary-function requirement, but the equivalent of that very requirement appears in the very next subsection, i.e., Section 170A(b)(1)(A)(iii).
When, the court noted, “Congress imposes a particular requirement in one subsection of a statute but not in another … the absence of the requirement is generally to be considered a deliberate omission that must be respected.” “When Congress includes particular language in one section of a statute but omits it in another—let alone the very next provision—this Court presumes that Congress intended a difference in meaning.” See Loughrin v. United States, 573 U.S. 351 (2014).
Section 170(b)(1)(A)(iii) “demonstrates that Congress knew how to incorporate a primary-function requirement into the definition and description of a qualifying organization when that was its intent. In [Section] 170(b)(1)(A)(iii) Congress provided for ‘an organization the principal purpose or functions of which are the providing of medical or hospital care or medical education or medical research, if the organization is a hospital,“ the court said. Section 170(b)(1)(A)(ii) “should not be understood implicitly to contain the very same requirement that is explicit in” (iii).
Under the regulation’s plain language, “the requirement is that noneducational activities [must] be ‘merely incidental to the educational activities.’ Requiring noneducational activities to be ‘merely incidental to educational activities’ to qualify as an educational organization seems another way of saying that an organization’s educational activities must be its primary purpose or function … Put another way, requiring all noneducational activities to be merely incidental to the educational activities means an organization could have no non-incidental or primary purpose other than education in order to qualify as an educational organization,” the court said.
It follows that Congress, unambiguously, did not include a merely incidental test in the statute. This absence of ambiguity in the statute means that the IRS’s interpretation of it is not entitled to the deference to which it would be entitled if the statute was silent or ambiguous “with respect to the specific issue.”
The parties disagreed, the court observed, whether Section 170(b)(1)(A)(ii) described a subset of educational organizations or defines the term, educational organization. The government took the former position while Mayo Clinic embraced the latter. On this issue, the court concluded, “the Government seems correct, but accepting that does not change the outcome.”
“Accepting that the term ‘educational organization’ is ambiguous does not contradict the conclusion that the regulation’s primary-function and merely-incidental requirements go too far. It means only that any regulation addressing that ambiguity must stop short of imposing a primary-function, merely-incidental, or equivalent requirement,” the court said.
The IRS maintained, in another attempt to sow ambiguity into the statute, that a “particular purpose” requirement should be read into the statute because it is inherent in the plain meaning of “educational organization.” The government posited that the “ordinary” and “definite” meaning of educational organization is “an organization whose particular purpose is to provide education.” Mayo Clinic relied on different dictionaries to argue that the ordinary meaning of educational organization is “an association…of or relating to education.” Mayo Clinic argued that the dictionary definition of educational organization plainly encompasses academic medical centers like itself.
The court was unmoved. It noted that the authorities cited by each of the parties did not show that the term, “educational organization,” as it is used in Section 170(b)(1)(A)(ii) is unambiguous one way or the other. The conclusion that a primary-function or merely-incidental requirement is inconsistent with Section 170(b)(1)(A)(ii) “is based primarily on the explicit presence of a primary-purpose test in the very next subsection of the same statute, i.e., Section 170(b)(1)(A)(iii).” That adjoining subsection was enacted at the same time as Section 170(b)(1)(A)(ii) and for the same purpose.
The IRS, as it had to, conceded that, during the taxable year at issue and to the time of trial, Mayo Clinic normally maintained a regular faculty and curriculum and normally had a regularly enrolled body of pupils or students in attendance at the place where its educational activities were regularly carried on. The government’s position that Mayo Clinic was not entitled to the refunds it sought was premised entirely on Mayo Clinic’s alleged inability to satisfy the primary-function and merely-incidental requirements in Treas. Reg. Section 1.170A-9(c)(1).
Because those requirements exceeded the bounds of authority given by Section 170(b)(1)(A)(ii), they were unlawful. Mayo Clinic, in the court’s view, qualified as an educational organization under Section 170(b)(1)(A)(ii) and was, therefore, entitled to summary judgment with respect to its refund claims.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.