​On February 10, 2023, the Pennsylvania Commonwealth Court issued four separate but related opinions denying property tax exemptions for four hospitals that had been purchased by the Tower Health system.^[1] In each case, the court determined that the owner of the hospital did not qualify as an “institution of purely public charity” and thus did not qualify for exemption from real property tax. The primary focus of these cases was on the compensation of hospital executives, the management fees paid by the separate hospital owners to the Tower Health parent company, and the level of services donated or rendered gratuitously to the public. These cases are important for tax-exempt hospitals and other tax-exempt charitable organizations that own real estate in Pennsylvania.

What You Need to Know:

• Recent decisions by the Pennsylvania Commonwealth Court have the potential to upset a delicate balance in the state of real property tax exemptions for nonprofit organizations across Pennsylvania.
• Courts are increasingly scrutinizing executive compensation, bonus structures, and the provision of gratuitous services, and nonprofits should consider the tax implications of these policies and decisions.
• Intracompany payments, or other fees paid between affiliated entities, are likely to trigger additional layers of review by courts, school boards and boards of assessments.
• Medicare and Medicaid reimbursements for medical services are being subject to stricter review by at least some courts, so nonprofit healthcare organizations should review their financial assistance policies.

Applicable Law – The HUP Test

Under the Pennsylvania Constitution, all state and local taxes must be imposed on a uniform basis, but the General Assembly may exempt certain entities from taxation, including “institutions of purely public charity.” In Hospital Utilization Project v. Commonwealth of Pennsylvania, 487 A.2d 1306 (Pa. 1985), the Pennsylvania Supreme Court ruled that an entity will only be considered an “institution of purely public charity” under the Pennsylvania Constitution if it satisfies all of the requirements of a five-part test (commonly referred to as the “HUP test”). To satisfy the HUP test, an entity must show that it: (a) advances a charitable purpose; (b) donates or renders gratuitously a substantial portion of its services; (c) benefits a substantial and indefinite class of persons who are legitimate subjects of charity; (d) relieves the government of some of its burden; and (e) operates entirely free from private profit motive.^[2] This test is significantly more restrictive than the requirements for qualifying for tax exemption under section 501(c)(3) of the federal Internal Revenue Code, and thus a nonprofit organization does not automatically meet the test for exemption for real property tax in Pennsylvania just because it is a section 501(c)(3) tax-exempt organization.

The Hospital Utilization Project decision triggered a great deal of litigation over when nonprofit institutions satisfied each of the HUP test requirements. In an attempt to provide more clarity and certainty and to codify the HUP test, in 1997 the Pennsylvania General Assembly enacted the Purely Public Charity Act (“Act 55”)^[3]. Act 55 contained a number of rules that were helpful to hospitals and other large nonprofit organizations. In 2012, the Pennsylvania Supreme Court ruled that the HUP test had to be interpreted and applied without regard to the provisions of Act 55 and that to qualify for exemption, a nonprofit organization had to satisfy both the HUP test and Act 55.^[4]

Background Facts

In 2017, Tower Health (which qualified as a section 501(c)(3) tax-exempt organization for federal income tax purposes), purchased a number of hospitals, including three in Chester County and one in Montgomery County, from a for-profit hospital system. The purchase was structured by putting each hospital in a separate limited liability company (each a “Hospital LLC”) owned by Tower Health. This structure meant that each separate Hospital LLC had to qualify, on a stand-alone basis, as an “institution of purely public charity” under both the HUP test and Act 55 in order to qualify for an exemption from property tax. Each Hospital LLC applied for property tax exemption for the hospital facility owned by it, but all four applications were rejected by the Board of Assessment Appeals and the Court of Common Pleas (the trial courts) in the applicable counties. In the decisions issued on February 10, the Commonwealth Court agreed that the Hospital LLCs failed to satisfy the HUP test, and that the hospital properties therefore did not qualify for exemption from real property tax.

Private Profit Motive

In each of the four Tower Health cases, the trial court had ruled that the Hospital LLC in question had failed to operate “entirely free from private profit motive” (the fifth element of the HUP test). The Commonwealth Court affirmed all of these determinations, making it impossible to satisfy the HUP test.

The courts focused, in particular, on whether the revenue of each respective Hospital LLC was used exclusively for that entity’s charitable purposes, or whether some of the revenue directly or indirectly “inured” to the benefit of any private individual related to the Hospital LLC or to related organizations. One of the facts emphasized by the Commonwealth Court in this regard was that each Hospital LLC paid substantial and “exorbitant” management fees to Tower Health, the parent organization (which operated as a holding company and did not directly engage in charitable activities).^[5] The courts also pointed to the fact that each Hospital LLC was a member of the “obligated group” liable to repay the bonds which were issued to raise funds to acquire the hospitals. This meant that each Hospital LLC pledged its assets and was obligated to pay interest on bonds that were used, in part, for different (but related) organizations. The foregoing issues likely would not have been an important factor if Tower Health had put all the hospitals in a single charitable organization that owned multiple hospital properties (as opposed to holding each hospital facility in a separate Hospital LLC).

The trial courts and the Commonwealth Court were particularly concerned by both the amount of compensation paid to key executives of Tower Health and by the fact that bonuses were tied, in part, to meeting financial performance goals.^[6] It was noted that Tower Health had to pay federal excise taxes due to its high levels of executive compensation. Moreover, the courts placed great emphasis on the fact that at least 40 percent of the bonuses payable to executives were tied to financial performance of the hospitals.^[7] The trial court in the Brandywine case found that “[i]t was very clear from the testimony of all the witnesses that the health system was set up to be profitable and to reward executives at all levels when it was. Its goal went far beyond self-support.”

Gratuitous Services

In each of the Chester County cases (Brandywine Hospital, Phoenixville Hospital, and Jennersville Hospital), the Commonwealth Court affirmed the trial court determinations that the Hospital LLC at issue had also failed to demonstrate that it donated or rendered gratuitously a “substantial portion of its services.” In contrast, the trial court in the Montgomery County case (Pottstown Hospital) determined that the Hospital LLC had met this requirement because it presented evidence sufficient to show that (a) it had a written policy to provide medically necessary care without regard to patients’ ability to pay, (b) it provided substantial services to Medicare and Medicaid patients for less than the actual cost of providing the services, and (c) it had written off significant bad debts.

These cases illustrate how difficult it is to predict how any particular trial judge will come out in applying the different elements of the HUP test. For example, the trial judge in the Pottstown Hospital case accepted the Hospital LLC’s argument that both (a) rendering services to Medicare and Medicaid patients at below cost, and (b) writing off bad debts, could be treated as the rendering of gratuitous services for purposes of the HUP test. In contrast, the trial judge in the Brandywine Hospital case rejected very similar arguments, and went so far as to claim that accepting Medicare and Medicaid payments actually increased the burden on government. It is difficult to determine whether the difference in result in these cases was due to a difference in the underlying facts, a failure by the Hospital LLCs in Chester County to present sufficient evidence to adequately substantiate their arguments, the fact that different judges can reach different conclusions on similar facts, or some other combination of factors. In each case, however, the Commonwealth Court accepted the factual findings of the trial judge on this issue

Key Takeaways

The Tower Health cases are extremely significant for tax-exempt hospitals and other charitable organizations. Key takeaways include:

• Great attention must be paid to both the level of executive compensation, and the manner of calculating incentive bonuses and incentive compensation. The organization should be prepared to justify all compensation as being reasonable and not in excess of arm’s length compensation. Tying bonuses or other compensation to financial performance metrics could, by itself, result in loss of status as an institution of purely public charity and must be scrutinized very closely.
• If an organization makes payments of any kind to related or affiliated organizations, or shares responsibility for indebtedness incurred by multiple entities, it is critical to show that such arrangements are reasonable, that the terms are at arm’s length, and that the payments benefit the organization making the payments.
• Each entity in a hospital system generally has to qualify as an institution of purely public charity on its own, even if that entity is disregarded for federal income tax purposes, and without regard to whether it is combined or consolidated with affiliated entities for financial statement purposes.
• Assessment Boards and School Districts may be taking a much harder look at whether a hospital satisfies the requirements that it renders gratuitously a substantial portion of its services and  relieves government of a burden in cases where a high proportion of the hospital’s revenues are derived from Medicare, Medicaid and other governmental programs. The Tower Health cases appear to have come out with opposite conclusions on these issues.
• Nonprofit organizations must keep good records to show that their compensation and intercompany payments are reasonable, and that they are providing services at less than their actual cost. These are factual issues that may need to be proven in court.
• It is extremely difficult to predict how a court will rule on whether the HUP test and Act 55 have been satisfied in any particular case. Different judges can come to different conclusions on very similar facts, and appellate courts are generally reluctant to reject factual findings of the trial court. Taking an exemption case to court is inherently hazardous and unpredictable. After the Hospital Utilization Project decision was issued in 1985, many large nonprofit organizations entered into “payment in lieu of tax” agreements (“PILOT agreements”) with local jurisdictions because they did not want to risk litigation over whether they satisfied the HUP test. Many of these PILOT agreements were allowed to lapse after Act 55 was enacted, because hospitals, universities and other large charitable institutions believed that the more clear-cut guidelines in Act 55 would be respected by the courts. The Pennsylvania Supreme Court’s position that Act 55 is merely an additional test to be satisfied to claim exemption from property tax, now coupled with the Tower Health cases, has increased the uncertainty in this area and may lead to a resurgence of PILOT agreements between large charitable organizations and local governments.
• The Tower Health cases may cause county boards of assessment to take a stricter position on applications for property tax exemption. Likewise, cash-strapped school districts may be more likely to challenge the exempt status of real estate held by nonprofit hospitals and other large institutions.

^{[1] The cases are Pottstown School District v. Montgomery County Board of Assessment Appeals, et al. (No. 1217 C.D. 2021) [to be reported], Brandywine Hospital, LLC, v. County of Chester Board of Assessment Appeals, et al. (Nos. 1279, 1280, 1283 & 1284 C.D. 2021) [to be reported], Phoenixville Hospital, LLC v. County of Chester Board of Assessment Appeals, et al. (Nos. 1281 & 1285 C.D. 2021) [not to be reported], and Jennersville Hospital, LLC v. County of Chester Board of Assessment Appeals, et al. (Nos. 1282 & 1286 C.D. 2021) [not to be reported]. The cases are referred to as the “Tower Health cases” in this Alert. 
[2] Hospital Utilization Project, 487 A.2d at 1317. 
[3] Codified at 10 P.S. § 371 et seq.
[4] Mesivtah Eitz Chaim of Bobov, Inc. v. Pike Cty. Bd. of Assessment Appeals, 44 A.3d 3 (Pa. 2012).
[5] It appears that each Hospital LLC was considered a “disregarded entity” for federal income tax purposes. In contrast, for Pennsylvania property tax exemption purposes, each Hospital LLC was generally treated as if it were a separate, “stand alone” charitable organization. This means that each Hospital LLC had to independently satisfy the five elements of the HUP test. The court suggested that intercompany fees would be prohibited “inurement” if the fees and expenses were in excess of arm’s length charges and did not advance the charitable objectives of the particular Hospital LLC that made the payment. This likely would have been less of an issue if a single entity had been used to own and operate all the hospitals.
[6] In addressing executive compensation, the Commonwealth Court appeared to treat Tower Health and the Hospital LLCs on an aggregate or combined basis, rather than treating the Hospital LLCs on a standalone basis.
[7] Tying 40 percent or more of an executive’s bonus to financial performance was seen as extremely troubling, and it made no difference whether bonus payments were actually paid or not. The court noted that Act 55 also prohibits tying compensation to financial performance. These bonus arrangements are a clear “red line.”}