IRS diagnoses a defect in Mayo Clinic

The Eighth Circuit’s decision was a partial win for the Service, which nonetheless does not acquiesce to the court’s holding regarding the formal-instruction requirement for tax-exempt educational institutions.
By Paul Bonner

The IRS signaled it will continue to defend its regulatory requirement that organizations primarily provide formal instruction to be considered educational organizations under Sec. 170(b)(1)(A)(ii).In an Action on Decision notice in November, the Service announced that it does not acquiesce to a portion of the holding by the Eighth Circuit in Mayo Clinic, 997 F.3d 789 (8th Cir. 2021).

Facts: Mayo Clinic is a not-for-profit corporation and tax-exempt parent organization of hospitals, clinics, and the Mayo Clinic College of Medicine and Science. In 2003, 2005-2007, and 2010-2012, it received income from partnerships for which it claimed an exception from unrelated business income tax (UBIT) on debt-financed property income under Sec. 514(c)(9)(C)(i) and Sec. 170(b)(1)(A)(ii).

After an audit, the IRS assessed more than $11.5 million in UBIT, denying that Mayo qualified as an educational organization for purposes of the UBIT exception under the statutes and Regs. Sec. 1.170A-9(c)(1) because Mayo's health care operations were more than an incidental part of its activities. Mayo paid the amount and sued for a refund in district court, which found the regulation invalid and held for Mayo (Mayo Clinic, 412 F. Supp. 3d 1038 (D. Minn. 2019); see "Tax Matters: Mayo Clinic Held to Be an Educational Organization Despite Engaging in Noneducational Activities," JofA, Nov. 2019).

The government appealed, and in May 2021, the Eighth Circuit reversed, finding the regulation partly valid, and remanded the case for further proceedings on whether Mayo qualified for the income exclusion.

Issues: Unrelated business taxable income of an exempt organization subject to UBIT includes, under Sec. 514, income arising from debt-financed property. However, certain qualified organizations may be exempt from UBIT with respect to income derived from, or on account of, certain debt-financed real property. Qualified organizations include, under Sec. 514(c)(9)(C)(i), educational organizations described in Sec. 170(b)(1)(A)(ii) (and certain affiliated support organizations).

An educational organization under Sec. 170(b)(1)(A)(ii) is any educational organization that 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.

Regs. Sec. 1.170A-9(c)(1) further delineates an educational organization under Sec. 170(b)(1)(A)(ii) as one whose "primary function is the presentation of formal instruction." Any noneducational activities may be no more than incidental to the organization's educational activities. For example, the regulation states, a museum operated by a school is not necessarily itself an educational organization, but a "recognized university" that incidentally operates a museum is one.

The district court held that Mayo met the statutory requirements and that the regulation's requirements of a primary function of presenting formal instruction and any other activity being no more than incidental exceeded the IRS's authority to interpret the statute.

Holding: In reversing the district court, the Eighth Circuit held that the regulation unreasonably limited educational organizations under Sec. 170(b)(1)(A)(ii) to those whose primary function is presenting formal instruction. That provision, promulgated in 1958, "has no long history of congressional acceptance," the court stated. Nonetheless, the regulation's distinction between primary and merely incidental activities has a valid role in interpreting the statute, the court said.

The regulation and statute must be read in the context of Sec. 501(c)(3)'s broad view of a tax-exempt organization's being organized and operated exclusively for a qualifying charitable purpose, the court said, noting that "exclusively" has generally not been construed literally but as allowing some other purposes, so long as they are not substantial in nature but are incidental to an organization's primary, qualifying purpose.

The IRS's nonacquiescence: In its Action on Decision, the IRS criticized the Eighth Circuit's finding that the formal-instruction requirement had no long history, stating that Congress has amended Sec. 170(b) "numerous times" since 1958 without overruling the regulation. Second, the formal-instruction requirement is based in the statute's requirements of a faculty, curriculum, and place of student attendance, the IRS stated. Third, the Service contended that the Eighth Circuit did not consider the IRS's arguments regarding over a dozen Code sections that cross-reference Sec. 170(b)(1)(A)(ii) (many of which predated the regulation's 1958 publication). These provisions, the IRS argued, support its position that the purpose of the formal-instruction requirement is to ensure that Sec. 170(b)(1)(A)(ii), as the Tax Court stated in Brundage, 54 T.C. 1468 (1970), "could not reach very far, if at all, beyond schools, colleges, and universities" (Brundage, at 1474).


  • Action on Decision 2021-04; Mayo Clinic, 997 F.3d 789 (8th Cir. 2021)

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