In a troubling decision, on March 4, 2004 the Massachusetts Appeals Court upheld the Appellate Tax Board’s (ATB) denial of a charitable foundation’s application for a property tax abatement on land owned by the foundation and leased to an affiliate of a hospital, also controlled by the foundation, and operated as an outpatient medical practice. The ATB found that the practice was not operated as a charity within the meaning of Mass. Gen. Laws c.59, §5, cl. Third (the Statute) and, therefore, that the foundation was not entitled to a property tax exemption on the land it leased to the practice.
The charitable purpose of Sturdy Memorial Foundation, Inc. (the Foundation) is to oversee the operations of, and otherwise support, Sturdy Memorial Hospital. Because the Hospital and its private medical staff were having difficulty recruiting a sufficient number of physicians to meet the needs of patients in the Hospital’s service area, the Foundation and the Hospital established Sturdy Memorial Associates, Inc. (the Practice) to recruit and employ physicians to meet this unmet need for physician services. The Practice has successfully responded to this need by recruiting physicians to practice at what are, in effect, Hospital affiliated medical practices. The Foundation, the Hospital and the Practice are all exempt from federal income tax under Section 501(c)(3) of the Internal Revenue Code and, as such, are exempt from state corporate excise and sales taxes. Many community hospitals and teaching hospitals have affiliated medical practices, which, like the Practice, are organized and operated on a non-profit, tax-exempt basis.
Nonetheless, the ATB denied the Foundation’s request for an exemption from the property tax assessed on the Foundation’s real estate leased to the Practice. The Foundation appealed, and the case proceeded to the Massachusetts Court of Appeals, which remanded the case to the ATB for additional factual findings (Sturdy I)1. Following its further factual findings, the ATB again ruled against the Foundation and the Foundation once again appealed to the Appeals Court. On March 4th, the Appeals Court announced its decision (Sturdy II). The Sturdy II opinion held that the ATB’s factual findings were reasonable and that the ATB could properly have inferred that the Practice was not a charity based on such findings. The ATB’s decision significantly limits the scope of the statutory charitable tax-exemption previously available to hospital-affiliated medical practices.
Though the Sturdy II decision does not provide any specific standards that a hospital- affiliated medical practice must meet to secure exemption from local property tax, its unquestioning deference to the ATB’s factual findings and legal conclusions and its implicit rejection of long-standing Supreme Judicial Court precedent, make this case noteworthy and worrisome for hospital-affiliated medical practices.
The ATB based its decision on two overarching findings. First, the ATB ruled that the incentive bonus plan for the Practice’s employed physicians constituted a diversion of charitable income to a limited class of persons. This finding, according to the ATB, demonstrated that the Practice was operated for the primary purpose of benefiting its physician employees (a small and discrete class of individuals) rather than the large and indefinite class required by the well-established case law interpreting the Statute. Under the bonus incentive plan at issue, physician employees were entitled to a bonus to the extent that their actual collectible fees exceeded their budgeted collectible fees. This bonus arrangement was competitive with other incentive bonus plans available to physicians in private practice as well as those employed by other non-profit, tax-exempt hospital-affiliated medical practices, and was designed to assist in the Foundation’s recruitment efforts by making employment at the Practice attractive to physicians willing to consider moving into the Hospital’s service area, and to further the Foundation’s charitable mission by rewarding physicians for caring for additional patients. Despite the Appeal Court’s determination in Sturdy I that paying competitive salaries to employees does not preclude an organization from being a charity, the Appeals Court in Sturdy II still considered it a “close question” of whether “diversion of this income to employee physicians in the form of bonuses” amounts to private inurement and, therefore, upheld the ATB’s legal conclusion with respect to this issue.
Second, the ATB held that the Practice was organized for a commercial purpose rather than a charitable purpose. The ATB based this finding on five factors, which are that the Practice:
provided medical care consistent with rates paid by third-party payors to private medical practices;
competed with private medical practices in the Hospital’s service area and was designed to be competitively attractive to potential physician employees;
had employment contracts with physician employees that emphasized productivity;
required patients to make appointments to see their physicians; and
allowed its physicians to limit their patient panels to approximately 2,000 – 2,500 patients.
The ATB’s findings demonstrate a fundamental lack of understanding about the financing and provision of physician services in Massachusetts. First, all physician services are provided at rates determined by governmental (e.g., Medicare and Medicaid) and private payors. The governmental rates are not negotiable and the private rates, for all but the largest health care delivery systems, are, in practice, also not negotiable. Even if the Practice could provide its physician services for rates below the established rates, most of the economic benefit would flow to the payors, not the patients, and either the Practice would have to reduce physician compensation, in which case it would soon fail in its primary mission of recruiting the physicians to meet the unmet need for physician services in the Hospital’s service area, or the Hospital and the Foundation would have to increase their subsidy to the Practice, which would draw resources away from their other charitable activities (e.g., emergency services provided without regard for the ability to pay). Second, it is not a requirement of state or federal law that charities pay below market compensation for the services of employees required to carry out its charitable purposes. This would not be good public policy. Wouldn’t you want your medical care to be provided by the best qualified physician available to the charity, rather than by the physician willing to work for the lowest salary? Moreover, if below-market compensation is now a requirement for charities seeking exemption from the local property, the Appeals Court has, sub silentio, overruled the Supreme Judicial Court’s holding in Harvard Pilgrim Health Care that the requirements for local property tax exemption are “virtually identical” to the requirements for tax-exempt status under Section 501(c)(3). It is a well-established principle of the federal law relating to tax-exempt status that tax-exempt organizations can pay market-rate compensation. As to competition with physicians in private practice, it is not a requirement for federal tax-exempt status or local property tax-exempt status that the charity refrain from competing with taxable entities. If this is a requirement for local property tax exemption, then non-profit hospitals, nursing homes, home health agencies, colleges and universities, all of whom compete with taxable entities, would all forfeit their exemption from local property tax. Third, as the court in the Sturdy I noted, it is not inconsistent with federal or state law to pay employees of a charity more if they work harder (i.e., treat more patients) in furtherance of the charity’s purpose (i.e., the promotion of health). Fourth, other than emergency services, most health care services offered by non-profit hospitals, clinics, medical practices, home health agencies, etc., are provided on a scheduled or “by appointment” basis. This simply reflects efficient management of charitable resources and proper respect for patient convenience. Would the public interest really be better served if patients had to simply show up at the Practice’s offices and wait their turn? Fifth, similarly, limiting patient panels also serves the interest of efficient management and patient convenience. All charities have resource constraints. It would be illogical and irresponsible to require as a condition of local property tax exemption, that medical practices, hospitals or other health care providers take care of more patients than they can safely accommodate.
The Appeals Court’s willingness to defer to the ATB’s rulings of law based on its imperfect understanding of the facts presented, and despite long-standing precedent to the contrary, including the Appeal Court’s own rulings in Sturdy I, raises serious issues for all hospital-affiliated medical practices in the Commonwealth.
1 In Sturdy I, the Appeals Court ruled that the Practice needed to meet two requirements to qualify for an exemption from property taxes, which are: 1) no private inurement; and 2) the class of persons benefiting from the operation of the Practice must be sufficiently large and diverse in order to demonstrate community benefit. Furthermore, the Court expressly held that the Practice had established that it treated a sufficiently large number of patients. Therefore, the only issue with respect to the second prong of this test was whether the type of patients typically treated by the Practice was too narrow. The case was remanded, in part, to confirm that the Practice treated patients drawn generally from the community and not from some narrowly limited class. The three-judge panel of the Appeals Court in Sturdy I was different from the three-judge panel in Sturdy II.