NJ Non-Profit Hospitals Beware: You May Be Nothing More Than a Legal - - PDF document

NJ Non-Profit Hospitals Beware: You May Be Nothing More Than a Legal Fiction By David N. Crapo July 2015 All across the United States, cash-starved municipalities are seeking to increase revenues. Fear

• f driving out businesses and residents, however, has made them wary of increasing property
• taxes. One source of revenue that municipalities are increasingly tapping are the larger nonprofits

within their borders – particularly medical centers and universities that occupy sizeable amounts

• f often prime real estate. Some municipalities have negotiated or are negotiating payments in

lieu of taxes (so-called “PILOTS”) with nonprofits. Other municipalities are seeking to revoke the nonprofit status of medical centers deemed not to be sufficiently charitable. On June 26, 2015, in an opinion that has already generated substantial commentary, the Tax Court of New Jersey (“Tax Court”) issued its fourth and final opinion (“2015 Opinion”) in AHS Hospital Corp., d/b/a Morristown Memorial Hospital v. Town of Morristown (Docket Nos. 010900-2007; 010901-2007; and 000406-2008), revoking, “essentially in its entirety,” the property tax exemption of Morristown Memorial Hospital (“MMH”). The Tax Court grounded its opinion on a purported “failure of evidence” – that is, the failure by MMH “to meet its burden

• f proof under law establishing that it meets the criteria to qualify for the exemption.”

Background MMH is a subsidiary of Atlantic Health System, Inc. (“Atlantic”) and is, therefore, part of the Atlantic Healthcare System. Historically, MMH enjoyed an exemption, pursuant to N.J.S.A. 54:4-3.6, from paying property taxes on the property it occupies in the Town of Morristown (“Morristown”). However, Morristown denied MMH’s claim for the property tax exemption for tax years 2006, 2007, and 2008 on the basis that MMH’s property is being used and operated for

• profit. MMH timely challenged the denial, initiating an action before the Tax Court. In all four
• pinions issued in the action, the Tax Court applied the three-part test for determining

entitlement to a property tax exemption enunciated by the New Jersey Supreme Court in Paper Mill Playhouse v. Millburn Twp., 95 N.J. 503 (1984). In three opinions, issued in 2010 and 2013, the Tax Court ruled that MMH had met the first two prongs of the Paper Mill Playhouse test, finding that: (i) MMH owns the property on which it conducts its operations and is organized exclusively for a tax exempt purpose; and (ii) nearly all of MMH’s property was used for hospital purposes. In the 2015 Opinion, however, the Tax Court ruled that MMH failed to present sufficient evidence that it met the third prong of the Paper Mill Playhouse test – that its property was not used “for profit.” It was that ruling that provided the basis for the revocation of MMH’s property tax exemption. Analysis The Tax Court began its analysis with a lengthy discussion of the structure and operations of the Atlantic Health System. Relying on various treatises of which judicial notice was taken, the Tax Court then addressed the history of hospitals, noting their origination as voluntary, generally religious charitable institutions established to care for the poor. Hospitals generally did not charge fees, and physicians generally offered their services for free. With technological

2 developments in the late nineteenth century, hospitals began their evolution into hybrid institutions receiving substantial charitable support that was used for capital improvements, but charging fees to those who could pay and operating on a day-to-day basis like businesses. Indeed, by 1903, self-paying patients constituted a substantial majority of those treated at hospitals in a number of jurisdictions in the United States. Nevertheless, the Tax Court concluded that, when the predecessor to N.J.S.A. 54:4-3.6 was enacted in 1913, hospitals were being run essentially the same way that they had been run in the early to mid-nineteenth century. The Tax Court then engaged in a detailed discussion of the development of the exemption of hospitals from property taxes. In this discussion, the Tax Court makes it clear that the exemption could be forfeited if the hospital property was used “for profit.” Based on this analysis, and although it acknowledged that the Legislature was aware of the evolving nature of hospital

• perations at the time the statute was enacted, the Tax Court concluded that “[t]he existence of

private, for-profit doctors who earned and retained fees generated on hospital property would have defeated a claim for property tax exemption under the clear language” of the predecessor to N.J.S.A. 54:4-3.6. An analysis of the components of the Tax Court’s decision follows. Medical Staff Physicians and RAP Doctors In light of its interpretation of the predecessor to N.J.S.A. 54:4-3.6, it is no surprise that the Tax Court concluded that the provision of medical services at MMH by non-employee, independent, voluntary physicians, who were members of MMH’s Medical Staff (“Medical Staff Doctors”) physicians with exclusive contracts with MMH who provided services in the areas of radiology, anesthesiology, pathology and emergency services (collectively, “RAP Doctors”), defeated MMH’s property tax exemption. The Tax Court was unable to “discern between the non-profit activities carried out by [MMH], and the for-profit activities carried out by [the Medical Staff Doctors and the RAP Doctors].” Similarly, the Tax Court was unable to delineate the specific areas in which the Medical Staff and RAP Doctors worked (or, more accurately, didn’t work) at

• MMH. Indeed, MMH’s president acknowledged that Medical Staff Doctors did their work

everywhere at MMH. Also fatal to the property tax exemption, Medical Staff and RAP Doctors used the MMH facility to generate private bills to their patients and were paid directly (and not through MMH) by their patients. The Tax Court’s findings demonstrate that MMH operates in the same manner in which most U.S. hospitals have operated for some time. Nevertheless, by doing so, MMH has, according to the Tax Court, forfeited its property tax exemption. MMH’s Relationships with For-Profit Affiliates The Tax Court was also troubled by MMH’s relationships with a number of affiliated and non- affiliated entities, including: (i) the physician practices it owns (“Captive Practices”); (ii) Atlantic Health Management Corp. (“Health Management”), a subsidiary of Atlantic that owned

• ther for-profit entities; and (iii) AHS Insurance Co. Ltd. (“AHS Insurance”), another Atlantic
• subsidiary. The Tax Court found that MMH used its property for profit-making purposes by

entangling its activities and operations with those entities, thereby conferring substantial benefits

• n them. Additionally, the Tax Court found that the connections and interrelationships between

MMH and those entities made it impossible for transactions between the entities and MMH to be considered arm’s length.

3 MMH acquired the Captive Practices to meet the “needs of the community,” to ensure that certain medical services continued to be provided in the community. 1 The Captive Practices remained for-profit entities after acquisition, although their employees were employed by MMH. With limited exceptions, the Captive Practices operated at a loss, providing “loss leader”

• services. The losses were covered by subsidies from MMH’s more profitable practice areas in

the form of working capital loans, capital loans, and recruitment loans. The Tax Court concluded that, by subsidizing the loss leader services provided by the Captive Practices, MMS was using its assets “for profit.” Moreover, by having MMH’s president serve as president and sole shareholder of each of the Captive Practices, the relationships between MMH and the Captive Practices were too entangled and intertwined to permit arm’s length transactions between them. Health Management is a for-profit subsidiary of Atlantic which directly or indirectly owned a number of for-profit affiliates. MMH’s CFO served as statutory officer for ten of Health Managements subsidiaries. MMH testified that Health Management and its subsidiaries constituted a very small part of the Atlantic Healthcare System’s business. Separate financial audits were conducted for Health Management and its subsidiaries to ensure independence. Generally, Health Management’s employees were not MMH employees. The only exception was that Morristown Surgical Center at Madison Ave. LLC, an indirect subsidiary of Health Management, was staffed by MMH employees. MMH made a loan of $550,000 for equipment to Morristown Surgical and made $910,000 in loans to AHS Investment Corp., a subsidiary of Health Management, to purchase equipment. By virtue of those loans, MMH conferred a substantial benefit on the Health Management for-profit subsidiaries in transactions that could not be considered arm’s length because MMH’s CFO served as president of Morristown Surgical and AHS Investment. By conferring such a private benefit on for-profit entities, the Tax Court held that MMH used its assets to generate profit. AHS Insurance is a “single-parent, captive” insurance company, whose sole business is to provide coverage to Atlantic and its nonprofit and for-profit subsidiaries, including MMH. MMH paid the premiums and expenses for all Atlantic subsidiaries, for-profit and nonprofit, but charged the premiums and expenses for the for-profit entities back to the for-profit entities. MMH’s CFO and General Counsel served as officers and directors of AHS Insurance. MMH’s risk and insurance department handled the analysis and administration of claims. AHS Insurance functioned largely as a bank account to pay claims. MMH, however, guarantied AHS Insurance’s line of credit and made capital injections into AHS Insurance. MMH contended at trial that all of the various transactions were properly charged back to AHS Insurance. Nevertheless, the Tax Court concluded that there was no “meaningful separation” between the for-profit and nonprofit subsidiaries of Atlantic, because MMH “called all the shots.” MMH also made loans to unrelated for-profit entities. According to the Tax Court, those loans “provide further evidence of [MMH’s] ‘commingling of effort and entanglement of activities’ to advance for-profit endeavors.”

1 Apparently, MMH represented to the Tax Court that it acquired the Captive Practices to continue the availability of

certain types of medical services (including general pediatrics and adolescent psychology) in the community (presumably meaning the less affluent areas of Morristown). According to MMH, operating independent practices to provide those services would not have been viable. Tax Court stated, however, that MMH did not provide evidence concerning the viability (or lack thereof) of independent practices serving the less affluent areas of Morristown.

4 Executive and Physician Compensation The Tax Court also scrutinized the compensation paid to certain MMH executives. MMH presented evidence of the procedure it followed to determine executive pay as well as an expert report in support of its compensation decisions. The Tax Court concluded that MMH had failed to demonstrate the reasonableness of compensation paid to its executives and for that reason was not entitled to a property tax exemption. In its analysis, the Tax Court criticized what it characterized as methodological weaknesses in MMH’s expert’s report. However, the Tax Court’s analysis was grounded largely in a rejection of MMH’s use of the IRS standard for determining the reasonableness of executive compensation. Although seeming to recognize that it was “generally the only one out there,” the Tax Court held that MMH “failed to convince” it that the IRS standard for determining whether executive compensation was reasonable was applicable in a New Jersey property tax case. However, the Tax Court never explained how or why the test used for determining the reasonableness of executive compensation in a property tax case would differ from the test used in a case involving another type of tax liability. Indeed, the New Jersey cases on which the Tax Court relied in its criticism of MMH’s utilization of the IRS standard utilized factors substantially similar to those included in the IRS standard. See International Schools Services, Inc. v. West Windsor Twp., 207 N.J. 3, 9 (2011); Kimberly School

• v. Montclair, 2 N.J. 28, 38 (1949); Trenton v. N.J. Div. of Tax Appeals, 65 N.J. Super. 1, 8, 166

A.2d 777 (App. Div. 1960). Nevertheless, the Tax Court concluded that, even if the IRS standard for determining the reasonableness of compensation were applicable in New Jersey tax cases, it would only apply to cases involving taxes similar to those imposed by the federal government and “[a]nything beyond that would require an act of the Legislature.” The Tax Court’s consideration of the compensation of MMH’s employee physicians focused on bonuses and incentive compensation and not on base compensation. The Tax Court criticized MMH for its failure to produce and validate the national surveys it used to determine physician compensation and to present testimony supporting its claim that it was common for hospitals to

• ffer incentive compensation to employee physicians. The Tax Court concluded that the

incentive compensation of MMH’s employee physicians demonstrated a profit-making purpose because it was structured as a type of profit-sharing. MMH’s Third Party Agreements MMH’s Third Party Agreements generally passed muster with the Tax Court. For example, MMH’s management agreement with a for-profit vendor to provide security at the visitor parking lot passed muster because the vendor was paid a fixed fee and MMH was responsible for the expenses of operating the garage. However, MMH’s Healthcare Support Services Agreement with Aramark did not pass muster, because it contained a profit-sharing component. The Aramark agreement, therefore, precluded MMH’s entitlement to a property tax exemption. Gift Shop The gift shop at MMH is run by volunteers and sells gifts that hospital patients might appreciate. The Tax Court determined that the gift shop constituted a “convenience” to visitors and was not reasonably necessary to MMH’s tax-exempt purpose. The Tax Court also noted that the gift shop

5 competed with commercially-owned stores. For that reason, the gift shop was not entitled to a property tax exemption. Auditorium, Day Care Area, Fitness Center, and Cafeteria The Auditorium and Fitness Center were found to be reasonably necessary to MMH’s tax- exempt purposes and were entitled to a tax exemption. Because it was possible that non- employee Medical Staff Doctors could use the Day Care Center, and the Cafeteria was run by Aramark on a contract with the same deficiencies as the Healthcare Support Services Agreement, those two areas were deemed not entitled to the property tax exemption. The outcome of the Tax Court’s opinion was that only the Auditorium, Fitness Center, and Visitors’ Garage were exempt from property taxes. Impact and Takeaways The Tax Court’s 2015 Opinion is and should be of great concern to non-profit hospitals in New

• Jersey. MMH’s tax exemption was revoked notwithstanding the Tax Court’s acknowledgement
• f the quality of the care and medical education provided by MMH and that MMH treats all

patients that walked through its doors regardless of ability to pay. In other words, the Tax Court did not find that MMH provided too little community benefit or was too aggressive in collecting

• bills. Rather, MMH lost is tax exemption in large part by operating the way many nonprofit

hospitals operate and have operated for some time. That MMH does so is of no moment to the Tax Court. In that regard, the Tax Court stated: “[i]f it is true that all nonprofit hospitals operate like [MMH], . . . then for purposes of the property tax exemption, modern nonprofit hospitals are essentially legal fictions.” According to the Tax Court, if modern nonprofit hospitals are to be entitled to property tax exemptions, it is up to the Legislature to amend the statute to so provide. According to media reports, MMH is currently considering its options, including an appeal of the 2015 Opinion. Additionally, media reports suggest the possibility of a legislative “fix” to 2015

• Opinion. 2 A resolution under either scenario will take time, however, which may actually delay

the date hospitals have to pay property taxes. There is also the possibility of a settlement between MMH and Morristown based on a PILOT payment program. In any event, media reports indicate that many New Jersey municipalities are beginning to consider assessing property taxes against non-profit hospitals. There are several takeaways from the 2015 Opinion:

• Hospitals should review their relationships, transactions, and dealings with related and

unrelated parties to determine any vulnerability to charges of profit sharing, particularly if there is a benefit flowing to a for-profit entity.

• Hospitals and medical staff attorneys and contract providers of services (e.g.,

anesthesiology, radiology, pathology, and emergency services) should consider restructuring their relationships, particularly the manner in which the physicians are being

2 In that regard, the Illinois legislature enacted such a legislative “fix” after the Illinois Supreme Court upheld the

revocation of the property tax exemption of Provena Medical Center in Champaign.

6 compensated for their services, to more closely align the interests of hospitals and physicians and to minimize accusations of profit sharing.

• When acquiring physician practices, hospitals should document the necessity for the

acquisition (e.g., whether the hospital actually needs to be the source of “loss leader” services like general pediatrics and adolescent psychology in an economically distressed community) and consider whether a complete integration of the practice into the hospital is legally, financially and organizationally feasible.

• To avoid charges of excess benefit, hospitals should take care to carefully and completely

document decisions concerning compensation and should avoid incentive compensation formulas that resemble and/or function like profit-sharing arrangements..

• Similarly, contracts with vendors should provide for fixed fees and should not contain

provisions resembling or functioning like profit-sharing.

• If a hospital chooses to self-insure, consideration should be given to structuring the self-

insurance plan as a trust, along the lines of a health benefit plan. For-profit affiliates should acquire their own insurance.

• Hospitals that are part of, or are considering becoming part of, accountable care
• rganizations, must carefully structure the relationships to avoid disqualifying

relationships and transactions with other entities, particularly for-profit entities.

• Similarly, hospitals engaging in the gainsharing arrangements advocated by health care

reform advocates must structure them carefully to avoid operating in a manner resulting in profit sharing with another entity, particularly if that entity is a for-profit entity. Most importantly, now is a good time for hospitals and their financial and legal advisors to review their structures, transactions, and relationships in light of the 2015 Opinion. David N. Crapo is Counsel in the Gibbons P.C. Financial Restructuring & Creditors’ Rights Department.