Morristown Memorial Hospital: The Nonprofit Property Tax Exemption Debate

As a qualifying U.S. charitable entity,¹ nonprofit hospitals receive several tax advantages relative to their for-profit counterparts. They are exempt from federal and state corporate income taxes, state and local property taxes, and sales taxes. They can access tax-exempt bond financing and provide tax deductions to donors for charitable contributions. Historically, hospitals were purely public charities dependent upon philanthropy, and given their vital role in the community, they were given these tax breaks to support their charitable mission. This tax exemption was a long-standing fundamental premise that allowed the government to encourage community benefit without directly burdening the taxpayers to provide funding. It reduced the charitable organization’s operating costs, allowing for the increased performance of its charitable mission.

To provide efficient and cutting-edge services, nonprofit hospitals have evolved to partner with for-profit organizations to obtain the financial, technical, and clinical resources necessary to provide state-of-the-art care. However, these arrangements have raised issues regarding the tax exemption of nonprofit hospitals, making them an increasing target of property tax exemption challenges for cash-strapped municipalities. Given the critical fiscal role of property tax as well as the burden the tax can place on taxpayers, charitable property tax exemption has emerged as a contentious issue in many locales (e.g., Kennedy and Johnson 2021; B. McKenna and N. McKenna 2010; Rosen 2006). Real estate property taxes are a significant source of revenue for local municipalities, as nonprofit organizations, especially incredibly sizeable property-owning ones, create budgetary challenges for cash-strapped municipalities seeking to balance their budgets. One option for avoiding the uncertainty of real property tax exemptions is for a nonprofit organization to make voluntary payments in lieu of taxes (PILOTs) (Brody, Marquez, and Toran 2012; Grønbjerg and McGiverin-Bohan 2016). Negotiations between individual nonprofit organizations and their respective municipalities generally determine the amount of the PILOT. However, for large, land-owning nonprofit hospitals, these voluntary PILOTs generally do not fully compensate the community for the services provided. Moreover, with property tax caps and other policies limiting revenue options, local officials began targeting the foregone nonprofit property tax as a source of revenue.

That is the situation that occurred when the town of Morristown (“Morristown”) levied omitted property tax assessments² of $37,430,000 on the hospital-owned property of Atlantic Health System (AHS) Hospital Corporation, doing business as Morristown Memorial Hospital (“Hospital”) for 2006 and 2007 tax years and a property tax assessment of $63,596,200 for the 2008 tax year. Morristown claimed that the Hospital was precluded from the property tax exemption because the activity on the property was conducted for profit. The Hospital appealed the assessment, and litigation ensued.

The Hospital was a wholly owned subsidiary of Atlantic Health System, Inc. (“AHS”), a nonprofit organization (Figure 1). It was a nationally ranked, nonprofit, acute-care teaching hospital with a reputation for excellence in medical care and education. The Hospital opened its doors in 1893 and, by the time of the property tax assessment, had evolved into a 1.1 million-square-foot campus on 40 acres (Figure 2) that provided essential services to the community, as derived from its mission:

The Hospital was a Level II trauma center with 700 beds, 385 surgery beds, and 50 beds for neonatal and obstetric care and Morristown’s most significant employer (approximately 5,500 employees). In 2008, the Hospital had over $1.4 billion of assets and annual revenue exceeding $1 billion. By 2019, assets had grown to over $4.1 billion and annual revenue exceeded $2.9 billion.³

The Hospital is a not-for-profit corporation organized under the laws of New Jersey for scientific, educational, and charitable purposes under Section 501(c)(3) of the Internal Revenue Code and is exempt from federal income tax. Because New Jersey conditions their sales, property, and corporate income tax exemptions for nonprofit entities to an organization’s 501(c)(3) status, the Hospital is also tax exempt at the state and local levels. To maintain this tax exemption, the Hospital must meet the “community benefit standard” established by the IRS. However, the IRS does not provide guidance on what constitutes community benefit, how it should be counted, or how much should be provided. Therefore, the standard gives nonprofit hospitals a broad latitude to determine which services and activities constitute community benefit and how they are calculated. General industry practice provides that community benefit activities include the costs of charity care (free or discounted services to patients who qualify under the hospital’s financial assistance policy and who would otherwise be unable to pay for the care); the unreimbursed cost of participation in means-tested government programs, such as Medicaid⁴; health professions education; health services research; subsidized health services; community health improvement activities; and cash or in-kind contributions to other community groups.

According to the AHS IRS Form 990s, the Hospital provided community benefits in all industry practice areas (Figure 3). In 2011, the AHS began publishing a community benefit report⁵ on its website to provide further details highlighting how the Hospital benefited the community.

Hospital patients generally had insurance coverage under Medicare,⁶ Medicaid, or commercial insurance or had no insurance coverage and were considered self-pay. Under the years in question, approximately 36 percent of Hospital revenue came from Medicare patients, with Medicare reimbursing 96–98 percent of the Hospital fee. Between 3 and 4 percent of revenue came from Medicaid, which covered approximately 40 percent of the Hospital fee. Beginning in 2010, the Hospital began reporting lost revenue under Medicaid as part of its community benefit (Figure 3).

Commercial insurance provided about 20 percent of the Hospital’s revenue, which generally provided a profit. Self-pay patients were responsible for paying their medical bills out of pocket, and the Hospital worked to set up a reasonable payment plan if necessary. If a person could not pay, they were eligible for free care under the Hospital’s charity care policy, and approximately 8 percent of the Hospital’s patients qualified for charity care. Regardless of insurance status, all patients who visited the Hospital door were treated. The Hospital also offered unprofitable services driven by community needs without regard to the financial impact on the Hospital.

The New Jersey Constitution⁷ exempts from taxation real and personal property owned by nonprofit corporations and used for charitable purposes. The controlling statute⁸ asserts that a three-pronged (organization, use, and profit) test must be met to secure a property tax exemption. The burden of proof lay with the Hospital to substantiate that the property met all three tax-exempt criteria.

The property an organization is claiming property tax exemption from must be owned by an entity organized exclusively for a tax-exempt purpose.

The property an organization is claiming property tax exemption from must be exclusively used for tax-exempt purposes. An organization claiming property tax exemption can have exempt and nonexempt uses on its property if the two purposes can be segregated and measured for local taxing purposes. The for-profit portion would fail the use test without jeopardizing the qualification of the balance of the property used for nonprofit purposes. However, the property tax exemption would be denied if substantial comingling of nonprofit and for-profit activities and operations occurs on the property and the court cannot differentiate between the two.

The operation and use of the property an organization is claiming property tax exemption from must not be conducted for profit. The essential focus is on whether the exempt entity engages in a forbidden profit-making activity for itself, meaning that the dominant motive behind the organization’s conduct cannot be to generate a profit. The bottom line for satisfying the profit test is that an entity claiming an exemption must have demonstrated that the operation and use of its property were not conducted for profit purposes.

In 2010, the New Jersey Tax Court determined that the Hospital property was owned by an entity organized exclusively for a tax-exempt purpose and nearly all the property was used for healthcare purposes (Casetext 2010), providing that the Hospital satisfied the first (organization) and second (use) prongs of the three-prong test. However, the judge ruled that the Hospital failed the third (profit) prong because profit-making medical services were provided throughout the Hospital and there was no separate accounting of nonprofit and for-profit medical activities to delineate exempt property from nonexempt property.

The Hospital appealed this denial of its claim for property tax exemption. In addressing the appeal, the Court focused on the operating structure of the Hospital rather than the amount of community benefit provided, re-examining the use and profit tests of the property tax exemption in the State of New Jersey. In their analysis, the court scrutinized the Hospital’s relationship with physicians, affiliated and nonaffiliated entities, and third-party agreements.

Three types of physicians provided care at the Hospital: employed, voluntary, and exclusive contract. Employed physicians were paid a base salary and provided employment contracts containing incentive compensation provisions. The incentives were calculated based on performance on qualitative and quantitative factors and paid out of their respective department’s incentive pool. The funding for the incentive pool varied by specialty but generally came from a portion of departmental revenues set aside for this purpose, with any remaining funds going to the Hospital. The Hospital also entered into employment agreements with other employed physicians to provide incentive compensation once revenue exceeded an established benchmark.

Voluntary physicians were private, for-profit, self-employed physicians who practiced in the community and had privileges to treat patients at the Hospital. During the years at issue, approximately 1,200 voluntary physicians had Hospital privileges, accounting for approximately 83 percent of Hospital admissions. The third group comprised approximately 120–150 physicians with exclusive contracts with the Hospital to provide radiology, anesthesiology, pathology, and emergency services. They were private, for-profit doctors not employed by the Hospital, even though they admitted and treated Hospital patients.

Voluntary and exclusive contract physicians could also participate along with employed physicians in Hospital leadership and medical staff functions, providing no distinction among physician types. Hospital billing was separate for voluntary and exclusive contract physicians. The Hospital charged the patient for facility utilization (e.g., nurses, technology, and overhead), and the physicians charged the patient for their professional services, operating as a for-profit business in a nonprofit facility. Under New Jersey law, the areas of the Hospital where these physicians practiced would be subject to property taxation. However, there were no limitations or restrictions on where any physician practiced in the Hospital, and voluntary and exclusive contract physicians could not be separated and accounted for from the employed physicians.

The Hospital owned 100 percent of the stock in five for-profit physician practices, known as captive PCs. A Hospital employee, Dr. Joanne Conroy, Vice President of AHS and President of the Hospital, was the sole shareholder of each captive PC and held shares in trust for the benefit of AHS (Figure 1). Practice Associates Medical Group, a captive PC, was a nonprofit subsidiary of the Hospital that provided billing services for these for-profit captive PCs.

All captive PC employees were considered Hospital employees, and the Hospital was responsible for all the income and expenses of these practices, which often generated millions of dollars in losses. To maintain the practices, the Hospital loaned millions of dollars to these entities to subsidize the losses, which officers of the Hospital testified were necessary to meet the community’s needs. In addition, recruitment loans were provided to physicians to move their practices to the community. The loans were often subject to 100 percent forgiveness after a certain period, at which time the loan forgiveness became taxable income for the physician. The captive PCs did not have an accounting department, and the Hospital prepared its financials.

The Hospital maintained a relationship with Atlantic Health Management Corporation (AHMC), a subsidiary of AHS that owned ten other for-profit organizations (Figure 1). Kevin Shanley, Vice President of Finance and Chief Financial Officer for AHS and the Hospital, also served as a statutory officer for the ten for-profit subsidiaries under AHMC. However, he was only compensated for work done for the Hospital and not for his service to AHMC. This arrangement put Mr. Shanley in the position of being on the executive boards of both lending and borrowing entities.

AHMC maintained separate employees, except for the Morristown Surgical Center, owned by AHMC but staffed by Hospital employees. There were several intercompany transactions between the Hospital and the surgical center. For example, the Hospital transferred $2.6 million to AHMC to cover the surgical center’s employee expenses. In addition, it made an apparent interest-free $550,000 capital loan to the surgical center to purchase equipment. Shanley was positioned to approve the transactions on behalf of the Hospital and AHMC. The Hospital also made interest-free loans to other AHMC subsidiaries, totaling $910,000.

AHS Insurance was a for-profit captive insurance subsidiary of AHS, organized under the laws of the Cayman Islands as a self-insurance trust fund providing insurance to cover the professional and general liabilities of the Hospital and its nonprofit and for-profit affiliates. The Hospital paid insurance premiums and expenses for all nonprofit and for-profit AHS subsidiaries, with the insurance cost charged back to the respective organization. Insurance risk was determined, and the Hospital’s employees handled claims, as AHS insurance had no employees and was essentially an offshore bank account holding cash and equity to pay Hospital claims. AHS Insurance also obtained a $10 million line of credit, which the Hospital guaranteed. The Hospital also contributed $18 million to AHS Insurance in 2009 and 2010 to cover stock market losses and large claim payouts for 2007 and 2008. Stephen Sepaniak, Esq., served as Vice President and General Counsel of AHS and the Hospital and as the President of AHS Insurance but was compensated only for his work as General Counsel for AHS and the Hospital.

The Hospital also provided $903,000 in loans to nonaffiliated, for-profit entities, with one loan being $200,000 to an organization that provided health insurance to physician practices.

Hospitals frequently contract with third parties to provide services on their property. In this case, the Court examined the parking garage and the areas of the Hospital where the cafeteria, laundry/linen service, and other support services were provided, including the gift shop.

Under a service agreement, the Hospital paid a monthly fixed management fee to Gateway Security Systems (“Gateway”). All workers were employed by Gateway, which maintained employee records and set wages, benefits, and employment terms. However, the Hospital reimbursed Gateway for employee salaries and other expenses and established parking fees. The parking fees went into a sweep account, and Gateway’s fees and other expenses were deducted from this account. Any remaining balance was transferred to the Hospital; however, the garage was operated at a loss.

Aramark provided the Hospital with management of food and nutrition services, catering, environmental services, laundry and linen distribution, patient transport, and plant operation maintenance. Hospital employees executed all services under Aramark management. The Hospital set a budget for Aramark and paid a fixed management fee. Aramark was responsible for any cost over-run of up to 25 percent of its management fee. If expenses were below the budget, Aramark kept 10 percent of the savings, and the remaining 90 percent reverted to the Hospital.

The Morristown Foundation Ladies Auxiliary ran a gift shop that volunteers staffed. The gift shop sold items that a visitor might bring to a patient in the Hospital or used personally and made a small profit that went to Hospital charitable activities.

The daycare center was made available only to Hospital employees, and it was unclear whether private physicians could use the service or who managed the facility.

The auditorium was used by support and community groups affiliated with the Hospital. It was also used for the Hospital’s officer election meetings, manager meetings, hospital operations, and community programs tied to community benefit assessment. However, it was unclear whether the Hospital charged organizations to use the auditorium.

The fitness center was restricted to Hospital employees who paid a minor fee. The area was not secured during the day, and whether nonemployees used the facility was unclear.

The impact of charitable property tax exemption on municipal revenue and the concern over whether nonprofit hospitals and health systems provide enough community benefit to justify their tax exemption has been a long-standing debate. With property tax caps and other policies limiting revenue options, local officials viewed nonprofits’ foregone property tax revenue as a potential target and charitable property tax exemptions came under attack. The question becomes whether modern-day nonprofit hospitals should maintain property tax exemptions, as the Court’s decision in this case could have a potentially far-reaching impact on hospitals, other nonprofit organizations, and municipal taxing authorities.

In June 2015, the Tax Court of New Jersey ruled that Morristown Memorial Hospital (Hospital) was not entitled to property tax exemption on nearly all its property in the Town of Morristown, NJ, where it operated. Although this was not the first time a nonprofit hospital faced a challenge to its property tax exemption (Cherry 2017), the situation attracted national attention due to the nature of the decision. In the ruling, the judge focused on the operating structure of the Hospital rather than the amount of community benefit provided, re-examined the “profit test” of the property tax exemption in the State of New Jersey, and amplified the nonprofit property tax exemption debate (Brino 2015). The question was whether a modern-day nonprofit hospital should maintain its property tax exemption, a decision with a potentially far-reaching financial impact on hospitals, other nonprofit organizations, and municipal taxing authorities.

The primary objective of this case study is to introduce the changing role of nonprofit organizations, specifically hospitals, and their relationship with their tax-exempt status and the communities they serve. Students debate whether the Hospital, under its current method of operation, satisfies the criteria for New Jersey property tax exemption and the legitimacy of tax exemption given the changing nature of nonprofit hospital operations. This case is appropriate for upper level undergraduate and graduate-level courses focused on nonprofit organizations and governmental or healthcare management.

The specific student learning objectives of the case are as follows:

• LO1: Recognize the changing nature of nonprofit healthcare organizations and the legitimacy of their tax exemption concerning market behavior.

• LO2: Apply analytical reading, information analysis, and critical thinking skills in formulating appropriate strategies to respond to property tax exemption challenges.

• LO3: Construct and defend a clear thesis.

The case study was implemented in four separate semesters in face-to-face and online graduate-level healthcare financial management courses at a private comprehensive college in the liberal arts tradition in the northeastern United States. This case led to a lively debate surrounding property tax exemptions in face-to-face classes. The discussion board in the online classes was very active, and the synchronous sessions rivaled the face-to-face classes for engagement. Students had little trouble understanding the basis of the property tax exemption challenge and generally held strong opinions one way or the other related to the issue.

We employed three primary methods to obtain evidence of case efficacy and student perception.⁹ First, after completing the case, all participating students (n = 86) responded to an anonymous survey. The students answered a series of statements about the case objectives and their beliefs regarding the difficulty and interest. The quantitative responses were based on a standard Likert scale ranging from 1 (strongly disagree) to 5 (strongly agree). See Table 1 for the key results of the student feedback questionnaire.

Overall, the survey feedback received from the students provided evidence that the case delivered on all the learning objectives. More specifically, students overwhelmingly responded that the case helped them understand the changing role of nonprofit organizations and their relationship with their tax-exempt status and the communities they serve.

Second, students were asked to complete a minimum two-page, single-spaced reflection paper discussing whether the case increased their understanding of nonprofit organizations’ issues regarding their tax exemption and their general impressions of the case. The narratives were analyzed using a phenomenological qualitative design, in which common themes for the reflections were extracted. Common themes emerged around students increasing their knowledge and understanding of nonprofit organizations’ challenges, improving analytical and communication skills, and increasing their ability to defend decisions. The quantitative and qualitative results support that the case delivered on all learning objectives and is worth undertaking.

Finally, independent faculty members were asked to review the case and provide comments. A faculty member from a large public university in the Southwest said, “The case is timely and on point with nonprofit hospital challenges. I could easily infuse this information into my undergraduate healthcare financial accounting course. The case would lend itself to a great in-class discussion to allow students to share their viewpoints on the nonprofit mission.” Another faculty member from a large public university in the South noted, “This case left me excited by the prospect of using it in my master-level governmental and nonprofit accounting course. This case provides an excellent entry point for students’ understanding of the ramifications of our rapidly evolving healthcare system in both the fields of healthcare finance and healthcare law. The tax exemption debate is simmering nationwide and only becoming more common and complex with time. The growth in recent years of the practice of state universities partnering with for-profit corporations to acquire rural and regional hospital networks is clearly going to be a future arena for this same sort of litigation. I believe this case study holds substantial promise for adoption into curricula as it provides a structured format for introducing concepts at a depth not currently available to instructors.”

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