Healthcare-system parent was not a qualified educational organization

Plain-English summary

A parent organization for an integrated healthcare system asked whether it was a qualified educational organization under section 170(b)(1)(A)(ii). That status would have allowed an exception from treating certain debt used to acquire or improve real property as acquisition indebtedness under section 514(c)(9). The IRS concluded that the organization's formal instruction through its schools was not its primary function because most expenses, employees, revenue, and contributions related to healthcare-system management, fundraising, development, clinical work, and research. The IRS therefore concluded that the parent was not a qualified organization for the requested exception, so the memorandum's analysis did not support excluding the relevant debt-financed income from unrelated business taxable income.

Ruling snapshot

• Question: Was the healthcare-system parent a qualified educational organization for purposes of the section 514(c)(9) exception?
• Outcome: Advice given, the parent was not a qualified organization under the facts presented.
• Key authorities: IRC §§ 170(b)(1)(A)(ii), 501(c)(3), 509(a)(1), 511, 512, 513, and 514(c)(9); Treas. Reg. § 1.170A-9(c)(1)

Full text (IRS public release)

INTERNAL REVENUE SERVICE

Release Number: 201407024
Release Date: 2/14/2014 TE/GE TECHNICAL ADVICE MEMORANDUM

Date: November 18, 2013
Internal Revenue Service
Attn: EO Mandatory Review UIL Code:
MC 4920 DAL
Code: 501.07-30
1100 Commerce Street
Dallas, TX 75242

Taxpayer's Name:
Taxpayer's Address:

Taxpayer's Identification Number:

Years Involved:

This memorandum responds to a request dated June 3, 2010, from TEGE Exempt
Organizations Examinations for technical advice. We have been asked to determine
whether Parent was a “qualified organization” within the meaning of I.R.C. §
514(c)(9)(C) during its 2005 and 2006 tax years. Our findings are set forth below.

ISSUE:

Whether Parent was a qualified organization within the meaning of § 514(c)(9)(C) for
purposes of determining whether income Parent derived from investment
partnerships can be excluded from unrelated business taxable income.

FACTS:

The Parent was originally incorporated on Date. The Parent filed an Application for
Exemption (“Application”) stating that among other activities that the main purpose of
the organization was to be the parent company of the healthcare system. The
Application stated that the “Parent will conduct the usual activities associated with
parent corporations in the tax-exempt healthcare field, including coordination of system-
wide activities, overall strategic planning, overall policy development, system-wide
medical education and medical research planning, capital and operating budgeting,
capital and resource allocation, system-wide fundraising, system-wide human resource
planning, legal compliance, system-wide accounting and reporting, oversight of taxable
entities within the system and so forth.” One of the main roles of the Parent is to hold
and /or manage portions of the significant investment portfolio of the health care
system.

According to its articles of incorporation, Parent is organized and operated:

_.. To conduct, execute, and perform a public trust to support, aid, and advance
the study and investigation of human ailments and injuries and the causes,
prevention, relief, and cure thereof, and the study and investigation of problems
of hygiene, health, and public welfare, and the promotion of medical, surgical,
and scientific learning, skill, education, and investigation, to conduct the practice
of medicine and surgery and allied sciences, to provide medical, surgical,
nursing, and hospital services, and to establish, operate, and coordinate clinics,
medical and surgical centers, hospitals, and similar facilities, to assist and
conduct or coordinate the conduct of, programs of medical education and
medical research and to offer programs of graduate and undergraduate
education and instruction in all fields of medicine, surgery, and related scientific
study or coordinate the same, and, in the broadest sense, to engage in and
conduct and to aid and assist in medical, surgical, and scientific education and
research, and to make such educational, charitable, and public gifts and carry on
such programs of public charity as may be incidental or related to the carrying
out of the other stated purposes of the corporation....

The organization was granted tax-exempt status under § 501(c)(3) and was classified
as a publicly supported organization under §§ 509(a)(1) and 170(b)(1)(A)(vi).

The Parent is set up as the parent entity of several separate subsidiaries, each of which
has their own EIN and tax-exempt status. These separate subsidiaries control the
various hospitals and clinics in the system, including a holding company that controls
certain for-profit entities owned by the Parent.

In addition to acting as the parent of the healthcare system, the Parent also operates
the Schools. The Schools were not part of the Parent when it was originally recognized
as described in § 501(c)(3) but were moved from another subsidiary to become an
operating division of the Parent at a later date. The Schools are not separately
incorporated. The Parent remained a publicly supported organization described in §§
509(a)(1) and 170(b)(1)(A)(vi) after the addition of the Schools as an operating division
of the Parent. The Schools represent 13% of the Parent's total functional expenses,
with the remaining 87% of expenses attributable to fundraising and development,
system-wide management, a medical journal, and “management and general.” Fewer
than 20% of the Parent’s employees, half of which are residents and other students, are
attributed to the educational program in the Parent's benefits and payroll system.
Educational revenues in 2006 constituted 6% of the Parent's total program service
revenue. Contributions categorized as educational normally represent about 7% of all
contributions received; of the remaining 93%, about 80% is categorized as “research,”
“clinical,” “charity/other,” or “capital” and 13% is categorized as “unrestricted.”

The Parent takes the position that it is a “qualified organization” within the meaning of
§ 514(c)(9)(B)(vi) because it is an "educational organization" described in §
170(b)(1)(A)(ii) and therefore does not have to treat indebtedness incurred in acquiring
or improving real property as “acquisition indebtedness” for purposes of § 514. Based
on this position, the Parent filed Form 990-Ts for the 2005 and 2006 tax years to report
unrelated debt-financed income in the amounts of $x1 and $x2 for investments that the
Parent made in several partnerships holding debt-financed real property. However, if
Parent is not a qualified organization within the meaning of § 514(c)(9)(A), the Parent
should have reported unrelated debt-financed income in the amounts of $x3 and $x4,
respectively.

LAW:

I.R.C. § 170(b)(1)(A)(ii) describes an educational organization as an organization that
normally maintains a regular faculty and curriculum and normally has a regularly
enrolled body of pupils or students in attendance at the place where its educational
activities are carried on.

I.R.C. § 511 imposes a tax on the unrelated business taxable income of organizations
otherwise exempt from federal income tax under section 501(c).

I.R.C. § 512(a) defines the term “unrelated business taxable income” as the gross
income derived by any organization from any unrelated trade or business (as defined in
§ 513) regularly carried on by it, less the deductions allowed by Chapter 1 of the Code
that are directly connected with the carrying on of such trade or business, both
computed with the modifications provided in § 512(b).

In computing unrelated business taxable income, § 514(a)(1) includes as an item of
gross income derived from an unrelated trade or business an amount that is the same
percentage (but not in excess of 100 percent) of the total gross income derived during
the taxable year from or on account of debt-financed property as (A) the average
acquisition indebtedness for the taxable year with respect to the property is of (B) the
average amount of the adjusted basis of such property during the period it is held by the
organization during the taxable year.

I.R.C. § 514(c)(9) provides that certain categories of exempt organizations are excused
from the debt-financed property rules with respect to the acquisition and improvement of
real property. Specifically, the term “acquisition indebtedness” does not include
indebtedness incurred by a “qualified organization” in acquiring or improving real
property. Among the types of exempt organizations that are defined as “qualified
organizations” are educational organizations described in § 170(b)(1)(A)(ii). When debt-
financed real property is held by a partnership, the exception under § 514(c)(9) does not
apply unless the partnership meets the requirements of § 514(c)(9)(B)(i)-(vi).

Treas. Reg. § 1.170A-9(c)(1) provides that an educational organization is described in §
170(b)(1)(A)(ii) if its primary function is the presentation of formal instruction and it
normally maintains a regular faculty and curriculum and normally has a regularly
enrolled body of pupils or students in attendance at the place where its educational
activities are regularly carried on. The term does not include organizations engaged in
both educational and non-educational activities unless the latter are merely incidental to
the educational activities. For example, the operation of a school by a museum does
not necessarily qualify the museum as an educational organization.

Rev. Rul. 76-416, 1976-2 C.B. 57, states that a hospital described in § 170(b)(1)(A)(iii)
that has established that it meets the public support requirements of § 170(b)(1)(A)(vi)
(describing organizations that receive a substantial part of their support from
governmental units or the general public) may qualify as an organization described in §
170(b)(1)(A)(vi). See also Rev. Rul. 78-95, 1978-1 C.B. 71 (a church described in §
170(b)(1)(A)(i) is not prevented by the regulations from also being described in §
170(b)(1)(A)(vi) if it meets the requirements for being publicly supported).

Rev. Rul. 56-262, 1956-1 C.B. 131, concerns an organization that was incorporated for
the primary purpose of engaging in research into the cause, origin, prevention, and cure
of certain diseases. The organization also provides advanced instruction and training of
personnel seeking to become qualified to engage in effective research operations in this
field. Two groups of students are maintained: research specialists of professional rank
and graduate students seeking the degree of Doctor of Philosophy in science.

Research specialists attend lectures and seminars which provide the opportunity for
acquiring knowledge and techniques relating to the research and the experimental
treatment of certain diseases. The graduate student program is carried out under an

agreement with a medical college whereby the facilities of the research organization are
made available to certain graduate medical students of the college. Formal instruction
taken by such students, who may or may not be employees of the research
organization, is deemed to be work done “in residence” at the medical college. The
ruling states that an organization which has educational activities in the broad sense of
the word and which, incidental to its primary functions, regularly maintains a faculty and
a curriculum and regularly has students in attendance at the place where its
educational activities are conducted, is not an “educational organization” referred to in §
170(b)(1)(A)(ii) of the Code. Only those “educational organizations” organized primarily
for, and engaged in, the presentation of formal education in the instructive sense
constitute “educational organizations” within the meaning of § 170(b)(1)(A)(ii) of the
Code.

Rev. Rul. 58-433, 1958-2 C.B. 102, concerns an organization that collects coins and
medals, maintains a museum and library that conduct summer seminar and scholastic
research projects, and provides instruction and supervision of post-graduate students.
The organization has an average of 35 persons on the post-graduate level during a
regular academic year studying numismatics and the history of numismatics, with each
student under the supervision and guidance of one of the organization's staff of experts.
In addition, the facilities of the organization are employed by scholars the world over,
either by attendance or by use of the organization’s publications to further their
research. The ruling holds that where the principal purpose and functions of the
organization are the collection and preservation of coins and medals and the
maintenance of a museum, library, and other facilities for research, with secondary
activities consisting of the employment of its museum, library, and other facilities in
furtherance of the organization’s educational aims in the graduate and post-graduate
study of numismatics and related fields, the organization does not constitute an
educational organization of the type referred to in § 170(b)(1)(A)(ii).

ANALYSIS:
Based on the facts and representations we rule as follows:

Parent was organized and operated during its 2005 and 2006 tax years as the parent of
an integrated health group practice. As part of its activities, Parent coordinates the
operation of Schools. The Parent also performs administrative duties for both the
Schools and the entire healthcare system, which includes hospitals, research centers,
clinics, and several taxable entities.

Parent maintains that it is an educational organization described in § 170(b)(1)(A)(ii).
Although, for foundation classification purposes, the IRS recognizes Parent as an
organization described in § 170(b)(1)(A)(vi), Parent may also be “described in” §
170(b)(1)(A)(ii) if it meets the requirements of that section. See Rev. Rul. 76-416; Rev.
Rul. 78-95. The Schools, which are an operating division of the Parent and not
separately incorporated, normally maintain a regular faculty and curriculum and
normally have an enrolled body of students in attendance at the place where the
educational activities are carried on. Thus, whether the Parent is an organization
described in § 170(b)(1)(A)(ii) hinges on whether it has, as its primary function, the
presentation of formal instruction.

While the Schools operated by the Parent may engage in the presentation of formal
instruction, we do not find, under the facts and circumstances presented, that the
Parent’s primary function is the presentation of formal instruction for the students of the
Schools. Nor do we find that the clinical and research practices are merely incidental to
the healthcare system’s formal educational program. Rather, we note that Parent's
formal instruction through the Schools represents only 13% of the Parent's total
functional expenses, with the remaining 87% of expenses being attributable to the
Parent's fundraising, system-wide management activity, development program, medical
journal, and “management and general.” About 20% of the Parent's employees, half of
which are residents and other students, are attributed to the educational program in the
Parent's benefits and payroll system. Educational revenues in 2006 constituted a mere
6% of the Parent’s total program service revenue, while contributions categorized as
educational normally represent only about 7% of all contributions the Parent receives.
Thus, the Parent’s formal instruction through the Schools is not the Parent's primary
function. Rather, the Parent's primary function consists of acting as the parent
company of a healthcare system by coordinating and planning system-wide activities
and conducting system-wide fundraising and development.

In this respect, Parent is similar to the organization described in Rev. Rul. 56-262 that,
although it maintained a regular faculty, curriculum, and student body, did not qualify as
an educational organization described in § 170(b)(1)(A)(ii) because formal instruction
was only incidental to its primary function of conducting research into the cause,
prevention, and cure of diseases. Like that organization, Parent’s primary function is
not the presentation of formal education in the instructive sense, but is, instead, serving
as the parent of an integrated enterprise that is educational in the broad sense of
“advanc[ing] the study and investigation of human ailments and injuries and the cause,
prevention, and cure thereof” (see Articles of Incorporation). The formal educational
activities of the Schools are incidental to that primary function.

Parent is similar, as well, to the organization described in Rev. Rul. 58-433 which also
did not qualify as an educational organization described in § 170(b)(1)(A)(ii) because,
though it used its museum and library to provide formal training for a small body of post-
graduate students, its primary purpose and function was to collect and preserve coins
and medals for general research. Like that organization, Parent, although it uses its
facilities for the formal training of students in its Schools, has as its primary purpose and
function the coordination of, and fundraising for, the clinical, research, and educational
components of the organization. Consequently, because we find that Parent's primary
function is not the presentation of formal instruction, we conclude that it does not qualify
as an educational organization within the meaning of § 170(b)(1)(A)(ii).

CONCLUSION:

Parent is not an educational organization as defined in § 170(b)(1)(A)(ii), therefore it is
not a qualified organization within the meaning of § 514(c)(9)(C).

This ruling is based on the facts as they were presented and on the understanding that
there will be no material changes in these facts. This ruling does not address the
applicability of any section of the Code or regulations to the facts submitted other than
with respect to the sections described. Because it could help resolve questions
concerning your federal income tax status, this ruling should be kept in your permanent
records.

A copy of this memorandum is to be given to Parent. Section 6110(k)(3) provides that
it may not be used or cited as precedent.

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