Public School Funding: Property Taxes
Public schools across the United States are funded primarily by property taxes. State and federal governments provide additional money, but the amount of that support varies widely between—and within—each state, leaving property taxes as the foundation for all public school budgets. Property taxes are based on the assessed value of the real estate—both the land and any buildings or homes constructed on it.
Critics have long argued that the local funding concept leads to systemic inequality of educational opportunities. Schools in districts with rising property values fare substantially better than schools surrounded by impoverished neighborhoods or empty commercial and industrial sites. Wealthy homeowners have the means to challenge overvalued property tax assessments, while poorer homeowners do not. The formula embodies the aphorism: The rich get richer and the poor get poorer.
Opposition to the property tax system ranges from grass-root, periodic protests to direct litigation, such as an action on trial now in Pennsylvania’s Commonwealth Court. In William Penn School District et al. v. Pennsylvania Department of Education et al., professional education advocates have sued state legislative leaders, state education officials, and the governor for failing to uphold their obligation under the state Constitution to provide a “thorough and efficient” system of public education.
Meds and Eds: Bastions of Property Tax Exemption?
Property tax inequities are compounded when local or municipal governments cap—or even eliminate—tax burdens to incentivize new or relocating employers. Equally vexing are large tracts of developed, yet valuable tax-exempt property dedicated to worthy, nonprofit missions such as education and health care. Within many U.S. cities, large, nonprofit hospitals, health centers, universities, and colleges—"meds and eds"—pay little, if any, property taxes, which shifts the burden of paying for local schools to all other property taxpayers. Exemptions for “meds and eds” are typically written into state laws governing “charities.” For the moment, the stronghold of the “meds and eds” property tax exemption seems well-fortified against legislative revision. Still, some “meds” have found a new snare: litigation that challenges their nonprofit nature.
A recent Pennsylvania trial court decision may be the warning shot across the bow of non-profit organizations whose operations—and compensation schemes—are more akin to those of for-profit real property taxpaying companies. A judge in the suburban-and-rural Chester County in southeastern Pennsylvania ruled that three local, nonprofit hospitals were not tax-exempt “charities,” thereby exposing them to begin paying millions in annual local property taxes. The decision is leading municipalities and school districts to consider sending property tax bills to nonprofit healthcare organizations.
Most hospitals and health centers are organized as nonprofit corporations and have received recognition as 501(c)(3) tax-exempt status by the IRS. More than two decades after for-profit hospitals entered the market, there are still twice as many nonprofit hospitals as there are for-profits in the U.S. The ratio is even higher in Pennsylvania: More than 75% of all hospitals there are organized as nonprofits.
The Tower Health Opinion
The Chester County Court ruled against three hospitals owned by Tower Health, a nonprofit corporation based in neighboring Berks County. Departing from over a century of nonprofit hospital tax decisions, Judge Jeffrey Sommer ruled that the Tower Health hospitals did not qualify as “charities” under the 1997 Institutions of Purely Public Charity Act (10 Pa. Stat. §371-385). The court held that the hospitals failed to prove that they had provided “uncompensated” patient care. The court also questioned the company’s administrative structure and executive compensation schemes that drained “huge sums … from the [hospitals and to Tower Health], resulting in the hospital ‘showing’ a large net loss.”
The court reached its decision in October 2021 after a two-week bench trial. The three Tower Health hospitals contended that they provided “charitable-care” by providing services for which Medicare and private insurers paid less than the hospitals wanted. The court disagreed, distinguishing between “undercompensated care” from truly “uncompensated"—or charitable—care. The court also ruled that the hospitals’ reliance on a “master charge sheet"—a common feature in hospital finance offices—was meritless, in part because the hospitals’ own witness “testified [that] the master charge sheet has no meaning or value. … [T]he numbers, essentially, are pulled out of thin air and are created only because [the hospital] is required to have a charge sheet to satisfy federal requirements.”
The three hospitals contended that they had each lost money, but the court noted that Tower Health had charged various fees in excess of $43 million to the three local hospitals in 2020 alone. The court noted that Tower Health executives were paid millions in annual compensation—well above the $1 million threshold for potential imposition of a 21.5% IRS excise tax. “Perhaps had each hospital not been required to pay exorbitant amounts to Tower Health for management fees and interest they would not have been ‘failing businesses.’” At its core, the Tower Health decision is a judicial duck test. That is, if a nonprofit organization looks and acts and compensates itself like a for-profit company, it may be treated as a for-profit company—or at least, it won’t be treated as a “charity.”
The Tower Health opinion acknowledges that the decision will be appealed. The judge actually implores the Legislature for a long-overdue modernization of the tax-status statutes to fit the current world of healthcare organizations and reimbursements. In the meantime, the Tower Health decision sounds a warning bell for non-profit healthcare organizations such as skilled nursing facilities, retirement communities, home healthcare enterprises, and others. Local townships, boroughs, and cities across Pennsylvania and beyond are examining how they can apply the decision to nonprofit organizations that operate similarly to for-profit counterparts.
Nonprofit organizations may want to pay close attention to the Tower Health decision. They may want to review:
- how and why revenue from a licensed healthcare enterprise is transferred to a parent—or supported—entity;
- the overall amount of local and parent company executive compensation—salary, bonuses, etc.; and
- billing and accounting practices with respect to genuinely uncompensated—as opposed to undercompensated—care.
Nonprofit institutions that want to avoid becoming tax targets like Tower Health may need to create affirmative evidence demonstrating that parent companies are paid commercially reasonable management fees, that their executives are not paid in excess of IRS guidelines, and that they provide truly uncompensated—rather than merely undercompensated—care. Still, the decision to tax nonprofit hospitals based on behavior more consistent with for-profit providers may not yield much, if any benefit to the taxing authorities: Even before the decision was issued, Tower Health announced that it would close two of the three community hospitals—Jennersville Hospital and Brandywine Hospital—by Jan. 31, 2022.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Author Information
Bill Kennedy is a partner in the Philadelphia office of White and Williams, LLP, where he defends and counsels a wide range of health care, senior housing, and manufacturing clients.
Jared Johnson is a partner in the Philadelphia office of White and Williams, LLP, where he provides tax representation and guidance on complex tax laws and disputes, corporate transactions, reporting, asset protection, and cross-border issues.
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