Mayo Case Raises Issues on Meaning of Educational Organization: Part I

In Mayo Clinic v. U.S., the issue presented was whether the Mayo Clinic, or Mayo, qualifies as an educational organization under Section 170(b)(1)(A)(ii). At stake in this case was whether Mayo was liable for nearly $12 million in tax on unrelated business taxable income, or UBTI, which both the government and Mayo agreed would not apply if Mayo was in fact described as an educational organization.

Background

Mayo is a Minnesota nonprofit corporation that is classified as a 501(c)3 tax-exempt organization. Mayo oversees health care system subsidiaries and operates the Mayo Clinic College of Medicine and Science, or Mayo College. The Mayo College is comprised of five distinct medical schools that offer M.D., Ph.D., and other degrees, as well as residencies, fellowships, and continuing medical education: the Mayo Clinic Graduate School of Biomedical Sciences, the Mayo Clinic School of Graduate Medical Education, the Mayo Clinic Alix School of Medicine, the Mayo Clinic School of Health Sciences, and the Mayo Clinic School of Continuing Professional Development. The medical schools comprising the Mayo College are all operating divisions of Mayo, not separately incorporated entities, so their activities and operations are a component part of Mayo.

During the tax years at issue, Mayo made investments in partnerships that had acquisition indebtedness with respect to real property, causing the income from the partnership to constitute debt-financed income under Section 514(b)(1) and, accordingly, to be classified as UBTI subject to the tax under Section 511(a)(1). Under a special exception to the debt-financed income rules under Section 514(c)(9)(A), however, acquisition indebtedness does not include indebtedness incurred by a qualified organization in acquiring or improving real property. For this purpose, a qualified organization includes an educational organization described in Section 170(b)(1)(A)(ii). Based upon it qualifying as an educational organization, Mayo took the position on its Form 990 that the exception to the debt-financed income rules applied and, therefore, that the partnership income was not UBTI.

The IRS asserted in a subsequent audit that in its view, Mayo was not an educational organization under Section 170(b)(1)(A)(ii) and therefore was liable for taxes on its debt-financed partnership income. Mayo paid the $11,501,621 of disputed taxes and in 2016 filed a lawsuit in federal district court seeking a refund on the basis that it meets the definition of an educational organization as specifically prescribed in the statute.

Meaning of ‘Educational Organization’

Under Section 170(b)(1)(A)(ii), an educational organization is defined as an 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.” Under this statutory language, there are four basic requirements to qualify as an educational organization: a faculty, a curriculum, students, and a place where educational activities are regularly carried out. Unlike the definition of a hospital under Section 170(b)(1)(A)(iii), which specifically includes a principal purpose requirement, there is no such principal purpose requirement such that, on its face, Section 170(b)(1)(A)(ii) does not require an organization to have education as its principal purpose in order to be classified as an educational organization. The language of Section 170(b)(1)(A)(iii) specifically requires the principal purpose to be the provision of medical or hospital care, among other health-care functions.

In addition to the statutory requirements in order to constitute an educational organization, Regulation 1.170A-9(c)(1) includes two additional requirements that do not appear explicitly in the statute, whereby an educational organization will only be described in Section 170(b)(1)(A)(ii) if its “primary function is the presentation of formal instruction” and its noneducational activities “are merely incidental to the educational activities.” With respect to the merely incidental requirement, the regulation provides the following example: “A recognized university which incidentally operates a museum or sponsors concerts is an educational organization within the meaning of section 170(b)(1)(A)(ii). However, the operation of a school by a museum does not necessarily qualify the museum as an educational organization within the meaning of this subparagraph.”

Under this regulation, an organization that otherwise may be an educational organization by virtue of maintaining a regular faculty and curriculum and having a regularly enrolled student body in attendance at a school facility, as prescribed under the statute, will not qualify as an educational organization under Section 170(b)(1)(A)(ii) unless its primary function is educational and any noneducational activities are merely incidental to the educational activities.

The matter would end up going to two different courts—both the federal district court and the U.S. Court of Appeals—and would result in two different outcomes. We’ll further examine those outcomes in Part II.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Richard L. Fox is a founding partner of the Law Offices of Richard L. Fox. He concentrates his practice in the areas of charitable giving, tax-exempt organizations, private foundations, estate planning, and trusts and estates.

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