In Mayo Clinic v. United States, the U.S. Court of Appeals for the Eight Circuit recently affirmed the district court decision that the Mayo Clinic qualified as an “educational organization” under Internal Revenue Code Section 170(b)(1)(A)(ii) and was therefore entitled to an $11.5 million refund of unrelated business income tax paid in prior years with respect to income from debt-financed property.
Unrelated Business Income Tax Basics
IRC Section 501(c)(3) organizations are generally exempt from paying federal income tax. However, to avoid a for-profit business tax loophole, if the organization carries on a trade or business that isn’t substantially related to its exempt purpose, the organization is subject to tax on its income from the unrelated enterprise. One category of unrelated business taxable income (UBTI) is income derived from debt-financed property. In layman’s terms, this means that if a tax-exempt organization borrows funds to make an investment, the income generated by that investment is treated as UBTI. Under IRC Section 514(c)(9), debt-financed income from certain real estate investments is excluded from the definition of UBTI when the income is received by an “educational organization” within the meaning of Section 170(b)(1)(A)(ii).
Facts and Court Holdings
Mayo Clinic is a tax-exempt organization under IRC Section 501(c)(3). In 2009, the IRS asserted that Mayo Clinic owed approximately $11.5 million in unrelated business income tax for income earned between 2003 and 2012 from its debt-financed property. Specifically, the IRS determined that Mayo Clinic wasn’t entitled to the exception in the unrelated debt-financed income rules available to educational organizations. Mayo Clinic paid the tax and filed for a refund.
In 2019, the district court granted summary judgment for Mayo Clinic, finding that it was an “educational organization” based on its organization and governance, educational offerings and day-to-day operations, significant investment in its schools and finances. As such, Mayo Clinic qualified for the exception under Section 514(c)(9) and was entitled to a full tax refund. On appeal, the Eighth Circuit in 2021 noted that to qualify as an “educational organization,” the organization’s primary purpose must be educational and its noneducational activities must be incidental to that primary purpose.
The Eighth Circuit remanded the case to the district court to determine whether Mayo Clinic’s overall purpose and operations were exclusively educational. In remanding the case, the appellate court emphasized that “the presence of a single non-educational purpose, if substantial in nature, will destroy the UBIT [unrelated business income tax] exemption regardless of the number or importance of truly educational purposes.”
On remand, the district court concluded that the term “primary” in this context means “substantial” and that Mayo Clinic had a substantial educational purpose and no substantial noneducational purpose during the relevant tax years. The court determined that Mayo Clinic uniquely integrated education, clinical practice and research across its operations such that “education is a substantial part of Mayo’s reason to exist.” The IRS appealed the court’s interpretation of the term “primary” in this context and its conclusion that Mayo Clinic lacked a substantial, noneducational purpose.
On appeal, the Eighth Circuit agreed with the district court’s interpretation of the term “primary” as “substantial.” The appellate court had difficulty pinpointing a singular, predominant activity for Mayo Clinic because its education, patient care and research functions were inextricably intertwined. It found, however, that the district court’s view was consistent with a Supreme Court case that found that a firm was “primarily engaged” in underwriting even though underwriting comprised at most 39% of its gross income and better aligned with the broad view of a tax-exempt purpose found in the Treasury regulations, which provide examples of museums, zoos, aquariums and symphony orchestras as “educational organizations.”
On the second issue, the appellate court concluded that Mayo Clinic’s nationwide hospital network and extensive patient care weren’t noneducational due to their integration with education.
Finally, the IRS argued that Mayo Clinic wasn’t an educational organization because it was a hospital or medical research organization described in Section 170(b)(1)(A)(ii). Addressing this issue, the court stated that Section 514(c)(9) doesn’t state that an organization may only qualify under one category of Section 170(b)(1)(A).
Win for the Taxpayer
Mayo Clinic provides a major win for academic medical institutions with integrated missions. The court holdings underscore that interwoven activities, even substantial commercial activities, can be considered exempt if they’re genuinely integrated into the organization’s primary exempt purpose. Specific documentation demonstrating this operational integration will be critical to achieving this result.
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