A district court held that Regs. Sec. 1.170A-9(c)(1) was invalid because the regulation impermissibly imposed the requirements that to qualify as an educational organization under Sec. 170(b)(1)(A)(ii), an organization's educational activities must be its primary function and its noneducational activities must be merely incidental to its educational activities. According to the court, Congress had intentionally not included these requirements in the statute.
Facts: Mayo Clinic, the parent company of several hospitals and clinics and Mayo Clinic College of Medicine and Science, is a nonprofit corporation and a Sec. 501(c)(3) tax-exempt organization. After an audit, the IRS concluded that Mayo was not an educational organization under Sec. 170(b)(1)(A)(ii) and thus was not a qualified organization for purposes of the Sec. 514(c)(9)(C) exclusion from unrelated business income (UBI) of income from debt-financed real property. As a result, the IRS determined Mayo owed tax of $11,501,621 plus interest, due to income it received from partnerships for seven tax years between 2003 and 2012. Mayo paid the taxes in 2016 and filed a suit for a refund in district court.
Issues: Tax-exempt charitable organizations, as defined by Sec. 501(c), generally pay tax on their UBI. A portion of an organization's income from debt-financed property is generally included in the organization's UBI. However, under Sec. 514(c)(9)(C), qualified organizations are generally allowed to exclude debt-financed real property income from their UBI. Qualified organizations include Sec. 170(b)(1)(A)(ii) educational organizations. Under Sec. 170(b)(1)(A)(ii), an educational organization is defined as "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."
According to Regs. Sec. 1.170A-9(c)(1),besides meeting the faculty-curriculum-student-place requirements in Sec. 170(b)(1)(A), the organization must meet two other requirements: It must have as its primary function the "presentation of formal instruction," and any noneducational activities must be no more than "merely incidental" to its educational activities. The IRS conceded that Mayo satisfied the faculty-curriculum-student-place requirements but argued that Mayo was not an educational organization because it did not satisfy the primary-function and "merely incidental" requirements of Regs. Sec. 1.170A-9(c)(1). Specifically, the IRS contended that Mayo's primary function was providing health care and that its health care activities were more than incidental to its educational activities.
Holding: The court held that the regulation was invalid because Congress intentionally did not include the primary-function and the "merely incidental" requirements in Sec. 170(b)(1)(A)(ii) when it wrote the statute; therefore, it held that Mayo was an educational organization and that it was entitled to the refund it sought. The court applied the analysis in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), to determine whether the regulation was valid. It stated the proper question was whether Sec. 170(b)(1)(A)(ii) is silent or ambiguous with respect to the issue addressed by the primary-function and "merely incidental" tests in the regulation. The court noted that laws must be interpreted by considering their surrounding provisions. Since Congress specifically included a primary-function requirement for medical care organizations in Sec. 170(b)(1)(A)(iii), the omission of that requirement in Sec. 170(b)(1)(A)(ii), which immediately precedes it, indicated that Congress intended to omit that requirement for educational organizations.
The court also held that Congress didn't intend to add the "merely incidental" test, because requiring noneducational activities to be no more than incidental to educational activities seemed to be another way of stating that an organization's educational activities must be its primary purpose or function.
- Mayo Clinic, No. 16-cv-03113 (D. Minn. 8/6/19)
— By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.