If a nonprofit hospital system creates a new tax-exempt subsidiary to own its medical office buildings, does that new subsidiary qualify for the same Texas sales and use tax exemption, and can supplies, services, and construction purchases for the buildings be bought tax-free?

Plain-English summary

A nonprofit hospital parent organization (TP), exempt from federal income tax under Section 501(c)(3) and from Texas tax under Texas Tax Code Section 151.310, planned to create a new tax-exempt subsidiary (COMPANY) to hold title to several medical office buildings (MOBs) near its hospital. Those buildings had previously been owned by a for-profit subsidiary (SUBSIDIARY B), which leased space mainly to physicians with hospital privileges. The new COMPANY would also be a 501(c)(3) organization and would send its net profits back to TP. An unrelated property management company handled leasing, billing, and day-to-day services (electricity, janitorial, pest control, garbage collection, landscaping) for the buildings, and one additional MOB was already under construction under a lump-sum contract with SUBSIDIARY B.

The Comptroller answered five linked questions:

1. Would COMPANY get the same exemption as its parent? Yes — as a 501(c)(3) entity, COMPANY would be eligible to claim exemption on purchases of taxable items related to its exempt purposes under Texas Tax Code Section 151.310(a)(1) and (2), just like other qualifying entities.
2. Would all supplies and services COMPANY buys to operate the MOBs be tax-exempt? The Comptroller referred back to the answer to Question 1 — the exemption applies to purchases related to COMPANY's exempt purposes.
3. Could the property management company buy supplies and services for the buildings tax-free if given a proper exemption certificate from COMPANY? Yes, but with a catch: under Rule 3.356(n)(3)(A), the management company must issue its own resale certificate to its suppliers and itemize the charges to COMPANY — in effect, the management company buys the goods and services and resells them to COMPANY, rather than simply passing the exemption through.
4. Could the in-progress construction contract for the new MOB be changed from "lump-sum" to "separated" billing? Yes, an in-progress contract can be modified this way, but only if the modification stays between the original contracting parties (the contractor and SUBSIDIARY B). If COMPANY is substituted in as a new party, that creates a new contract rather than a modification of the existing one.
5. If the contract is changed, can the contractor recover tax already paid on past purchases and refund it to COMPANY? No — the contractor cannot recover tax already paid on past purchases.

What this means for you

Nonprofit hospital systems restructuring real estate holdings

Moving medical office buildings into a newly formed 501(c)(3) subsidiary doesn't automatically inherit the parent's exemption in some generic sense — but a properly qualifying subsidiary can independently claim exemption under Texas Tax Code Section 151.310(a)(1) and (2) for purchases tied to its own exempt purposes. Structure and paperwork still matter for each purchase.

Property management companies serving exempt clients

If you manage buildings for a tax-exempt owner, getting an exemption certificate from that owner doesn't let you simply pass your own purchases through tax-free. Under Rule 3.356(n)(3)(A), you must issue a resale certificate to your suppliers and itemize charges back to the exempt owner — you're treated as buying and reselling the goods and services, not as making exempt purchases directly.

Businesses mid-construction who want to restructure ownership

If you're trying to convert a lump-sum construction contract to a separated contract to capture a tax exemption, the change must happen between the same original parties. Substituting in a different legal entity (even a related, newly formed one) as owner creates a new contract, not a modification — and you can't retroactively recover tax already paid under the old arrangement.

Common questions

Q: Does a new nonprofit subsidiary automatically get its parent hospital's Texas tax exemption?
A: Not automatically as an extension of the parent's exemption, but this letter confirms that a subsidiary that is itself a Section 501(c)(3) organization is eligible for the same type of exemption under Texas Tax Code Section 151.310(a)(1) and (2) for purchases related to its own exempt purposes.

Q: Can a property management company buy supplies tax-free using the exempt building owner's exemption certificate?
A: Yes, if provided with a properly completed exemption certificate, but Rule 3.356(n)(3)(A) requires the management company to issue a resale certificate to its own suppliers and itemize the charges to the owner — effectively buying and reselling the goods and services rather than passing the exemption straight through.

Q: Can we switch an existing lump-sum construction contract to a separated contract to get a tax exemption?
A: Yes, an in-progress contract can be modified from lump-sum to separated, but only between the original contracting parties. If a different entity is substituted as a party, that counts as a new contract rather than a modification of the existing one.

Q: Can a contractor get a refund of sales tax already paid on a project once the contract is changed?
A: No. This letter states the contractor may not recover any tax already paid on past purchases.

Q: Can other taxpayers rely on this letter?
A: This opinion is based on the specific facts presented to the Comptroller, and the letter itself notes the opinion may change if the facts are different or additional facts arise.

Citations and references

Statutes and rules:

• Texas Tax Code Section 151.310 (exemption for religious, educational, and charitable organizations), including subsections (a)(1) and (a)(2)
• 34 Tex. Admin. Code Rule 3.356(n)(3)(A) (contractors; resale certificates)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9508938L

Original ruling text

August 23, 1995

Dear **:

Thank you for your letter of July 19, 1995, concerning your client's
(**) Texas sales and use tax responsibilities.

Facts:

** (TP) is a non-profit institution which is exempt from federal
income tax under Section 501(c)(3) of the Internal Revenue Code. TP also has
been extended an exemption from Texas taxes under Texas Tax Code Section
151.310. TP is the parent corporation to several second tier entities all of
which are involved in some capacity in providing healthcare services to the
public. One of the subsidiaries, ** (SUBSIDIARY A), is also a
Section 501(c)(3) which operates an acute care hospital located in Bryan,
Texas. Another TP subsidiary, **, (SUBSIDIARY B) is a for-profit
corporation that owns four medical office buildings (MOBs).

TP's board realized a number of years ago that in order to provide a high
quality of healthcare in its service area, the hospital would have to ensure
that they could attract and keep quality physicians and medical specialists to
practice at their hospital. An important factor to physicians and medical
specialists when considering locating their practices is the questions of
adequate office space available in an area near the hospital. In an effort to
attract and maintain physicians to locate their practices near its hospital, TP
began acquiring office buildings near its campus. SUBSIDIARY B was established
as a for-profit subsidiary of TP to own the MOBs due to the fact that in some
instances, the MOBs were to be jointly owned with private physician groups.
Since that time, SUBSIDIARY B has purchased the partnership interests in the
MOBs from the physician groups and now owns 100% of all properties.

The office buildings owned by SUBSIDIARY B are operated by an unrelated
property management company. The management company handles the leasing
activities, contracts for the day-to-day expenses required to operate the
building and bills and collects rents from physicians leasing space in the
building. The property management company will sometimes contract for the
remodeling or finish out of lease space for new tenants. SUBSIDIARY B will
often negotiate contracts directly with contractors to have this work
performed.

While the majority of MOB space is leased to physicians that have privileges at
the hospital, some of the space is utilized by SUBSIDIARY B for storage and
miscellaneous office space. The management company will purchase the services
necessary to maintain the buildings. These services include: electricity,
janitorial, pest control, garbage collection and landscaping. The management
company recovers the cost of these services from tenants via a monthly
maintenance fee. SUBSIDIARY B is billed for the services that pertain to
portions of the property that they occupy and also for the common areas of the
property.

In addition to the four (4) MOBs currently owned by SUBSIDIARY B, the entity
has also contracted for the construction of an additional medical office
building. Similar to the other MOBs, the office space in the new office
buildings will be leased to physicians that have privileges at SUBSIDIARY A
hospital. SUBSIDIARY B has entered into a lump-sum contract with the contractor
that is building the new MOB.

For business and tax reasons, TP now is planning to establish a newly created
tax exempt subsidiary that will own the MOBs. This new entity (COMPANY) will be
a Catholic sponsored organization and afforded Section 501(c)(3) status by the
IRS. COMPANY's sole purpose will be to hold the title to the MOBs currently
held by SUBSIDIARY B and to distribute net profits back to TP.

Issues and Questions:

For federal tax purposes, income from rentals to physicians of a MOB by a
501(c)(3) entity is exempt from federal income tax because the operation of the
building is related to the hospital's exempt purpose. That is, the MOB suites
leased to physicians contributes to the exempt purpose of the hospital by
allowing the hospital to attract and maintain physicians to provide healthcare
services. Additionally, the IRS will recognize the exempt status of a separate
non-profit entity established solely to own the MOBs if any profits are
returned directly to a non-profit hospital.

Question 1. Will COMPANY, a stand alone non-profit 501(c)(3) corporation owning
the MOBs, receive the same exempt standing from the Comptrollers Office as does
its parent, TP? If not, please explain.

Answer: COMPANY, a 501(c)(3) entity, will be eligible to claim exemption on
purchases of taxable items related to its exempt purposes as are other entities
qualifying for exemption under Texas Tax Code Section 151.310(a)(1) and (2).

The property management company will continue to operate the MOBs to be owned
by COMPANY. However, COMPANY will purchase supplies and contract for certain
services related to the MOBs directly with vendors. For instance, COMPANY may
engage contractors to perform remodeling of physician suites in an MOB.

Question 2. If the answer to Question 1 is yes, (COMPANY is exempt), will all
supplies and services purchased by COMPANY for operation of their medical
office buildings be exempt from Texas tax? If not, please explain why.

Answer: See the answer to Question 1.

Question 3. If provided with a properly completed exemption certificate from
COMPANY, can the property management company purchase supplies and services
necessary to operate the MOBs tax free? If not, please explain.

Answer: Yes, however Rule 3.356(n)(3)(A) will require the management company to
issue a resale certificate to the suppliers and itemize the charges to COMPANY.
In essence, the management company must buy the goods and services and resell
them to COMPANY.

COMPANY will own the existing MOBs and also hold title to the MOB currently
under construction. In order to take advantage of COMPANY's tax exempt status,
the contract terms for construction of the new MOB may be changed from lump sum
to separated. The contractor has indicated a willingness to modify the contract
for this purpose.

Question 4. Can the contract for the construction of the current MOB between
COMPANY (the successor to SUBSIDIARY B) and the contractor be altered to change
the terms of the contract from a "lump-sum" to a "separated" contract?

Answer: An in-progress new construction contract may be modified by the parties
to change the terms of the contract from lump sum to separated. However, the
change must be between the original parties to the contract (the contractor and
SUBSIDIARY B). Changing one of the parties to the contact results in a new
contract rather than the modification of an existing contract.

Question 5. If the answer to Question 4 is yes, can COMPANY's contractor
recover any tax paid on past purchases applicable to the MOB from its vendors
and refund the tax to COMPANY? If not, please explain.

Answer: The contractor may not recover any tax paid on purchases (see the
answer to Question 4).

This opinion is based on the facts presented. If there are additional or
different facts, the opinion may change.

You may call me toll free 1-800-531-5441, extension 3-4683. The direct line is
512/463-4683. You may also write to Tax Policy Division, Comptroller of Public
Accounts.

Sincerely,

Eddie C. Washington
Tax Policy Division