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The New Jersey Tax Court’s AHS Hospital Decision: Judge Bianco Lays Down the Gauntlet

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Corporate & Finance Alert

July 8, 2015

By: Peter J. UlrichBozena M. Diaz

In a detailed and closely-watched decision issued on June 25, 2015, Judge Vito Bianco, a New Jersey Tax Court judge sitting in Morristown, has denied a property tax appeal of Morristown Memorial Hospital (the “hospital”). AHS Hospital Corp., d/b/a Morristown Memorial Hospital v. Town of Morristown. The hospital had sought to overturn the Morristown tax assessor’s denial of its property tax exemption for tax years 2006, 2007 and 2008 as a non-profit hospital under N.J.S.A. 54:4-3.6. The hospital contended that “the traditional and historic means by which hospitals . . . provided hospital services” are the same today as they were at the time New Jersey first adopted a specific tax exemption for “[a]ll buildings actually used for . . . hospital purposes.” The Town of Morristown argued that the operation and use of the hospital property was being conducted for profit, thus precluding its exemption from property tax.

The Tax Court focused primarily on the third prong of a three-part test articulated in Paper Mill Playhouse v. Millburn Twp., 95 N.J. 503 (1984). Under that three-prong test, to secure an exemption under N.J.S.A. 54:4-3.6, (1) the subject property must be owned by an entity organized exclusively for a tax-exempt purpose; (2) nearly all of the subject property must be actually used for exempt purposes; and (3) the operation and use of the subject property must not be conducted for profit. Noting that although an organization claiming an exemption is permitted to have both exempt and non-exempt uses occurring on its property, the court emphasized that such non-exempt uses must be conducted so as to be “evident, readily ascertainable, and separately accountable for taxing purposes” and that where a court is unable to discern between the non-profit and for-profit activity, the exemption must be denied, citing the New Jersey Supreme Court’s decision in International Schools Services, Inc. v. West Windsor Twp., 207 N.J. 3, 24 (2011).

In assessing whether the third prong of the three-part test was met, the Tax Court analyzed a number of the hospital’s arrangements, including (1) the hospital’s relationships with private, for-profit physicians and a number of affiliated and non-affiliated for-profit entities; (2) employee physician contracts; and (3) various third-party agreements, including contracts with Gateway Security Systems and Aramark, a food and nutrition service company. With respect to the hospital’s relationships with private physicians, the court held that it was unable to determine where the physicians practiced on the hospital property and where they did not, and thus was unable to discern between the hospital’s non-profit activities and the for-profit activities carried out by the physicians. Accordingly, the Tax Court ruled that the hospital’s arrangement with those physicians directly violated the requirement articulated in International Schools, supra, and so the hospital must be denied the exemption. With respect to the hospital’s relationships with the for-profit entities, the court held that it was evident that the hospital, by entangling its activities and operations with those of for-profit entities (by providing loans and paying insurance premiums, to name just a few of the examined transactions), it allowed its property to be used for profit, even if it did not profit from the activities itself.

With respect to the hospital’s employment contracts, the Tax Court, citing to Hunterdon Med. Ctr. v. Township of Readington, 195 N.J. 549 (2008), held that because the employed physicians were given an incentive component (in addition to their base compensation) which was tied into the hospital’s profits, revenues, or expense savings, the contracts demonstrated a profit-making purpose. With respect to the contract with Aramark, the Court held that because Aramark shared in certain budgetary savings, the arrangements evidenced a profit-making purpose typical of “commercial activity or business venture.” The Tax Court contrasted that with the contract with Gateway, which was viewed as satisfactory by the court because it provided for only a fixed management fee. The court also looked at the hospital’s executive compensation arrangements, finding that the hospital failed to meet its burden to establish the reasonableness of the compensation paid to its executives.

The Tax Court excepted certain hospital operations from the denial of the exemption, including the hospital’s auditorium, fitness center and visitor’s garage, primarily because they did not generate any revenue. At the same time, however, the court denied the exception for a day care center and a gift shop, holding that the day care facility would not be exempt because it was not clear who could use it, who managed it, or whether a fee was paid for the services, and that the gift shop was not “reasonably necessary for the hospital’s tax-exempt purposes,” did not provide any medical service to the hospital’s patients, and was merely a convenience for hospital visitors. Judge Bianco previously ruled on similar grounds in AHS Hospital Corp. v. Town of Morristown, 25 N.J. Tax 374 (Tax 2010), by holding that the hospital’s Au Bon Pain cafe and certain office space rented to physicians were taxable.

Judge Bianco’s June 25, 2015 decision is significant to both the New Jersey health care industry, in that it could eviscerate the property tax exemption for modern integrated hospitals, and potentially for other nonprofit organizations with complicated corporate structures or relationships. Admittedly, it may be premature to make major business decisions based on the Tax Court decision. One can not help but think that the decision will be appealed to the Appellate Division, and possibly even the New Jersey Supreme Court. Yet, depending on the final outcome of this decision, as well as another before Judge Bianco relating to Princeton University, the property tax landscape for major nonprofit organizations in New Jersey may be about to change.