Eighth Circuit in Mayo Clinic Decision Partially Upholds Educational Organization Regulation and Remands Case

The U.S. Court of Appeals for the Eighth Circuit in Mayo Clinic v. United States partially upheld, and partially rejected, the "educational organization" regulation at the heart of the case. The result was the court found that the summary judgment record was insufficient to grant victory to either the Clinic or the government and so remanded the case for further proceedings. This result means that the government has avoided, for the most part, a major expansion of an exception not only to the unrelated business income tax debt-financed rules but also an exception to the definition of private foundation. 

The regulation at the heart of the case is 26 C.F.R. § 1.170A-9(c)(1), which provides:

An educational organization is described in section 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 includes institutions such as primary, secondary, preparatory, or high schools, and colleges and universities. It includes Federal, State, and other public-supported schools which otherwise come within the definition. It does not include organizations engaged in both educational and noneducational activities unless the latter are merely incidental to the educational activities. A recognized university which incidentally operates a museum or sponsors concerts is an educational organization within the meaning of section 170(b)(1)(A)(ii). However, the operation of a school by a museum does not necessarily qualify the museum as an educational organization within the meaning of this subparagraph.

The Clinic challenged the "primary function" and "merely incidental" requirements of the regulation, successfully asserting in federal District Court that these tests were inconsistent with this statutory definition of educational organization found in Internal Revenue Code § 170(b)(1)(A)(ii)):

an educational organization which 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

For the Clinic this issue was critical because if, as the District Court found in granting the Clinic's motion for summary judgment, it qualified as an educational organization it was exempt from unrelated business income tax on its debt-financed income to a tune of more than $11 million over the seven years at issue. But a larger ramification of the District Court's holding was that Internal Revenue Code § 501(c)(3) educational organizations are also not private foundations under IRC § 509(a)(1). So if the District Court's view prevailed, a charity that otherwise would be classified as a private foundation likely could have escaped that classification and the restrictions that come with it by simply operating a modest educational program.

However, based on a lengthy discussion of the legislative history of sections 170 and 501(c)(3), the appellate court concluded the District Court was only partially correct. The appellate court agreed that the regulation incorrectly added the "primary function [must be] the presentation of formal instruction" test. At the same time, it found that it was appropriate to interpret the statute as requiring an educational organization both to have being educational as its primary purpose and to limit its noneducational activities to being merely incidental to that primary purpose. It then found the summary judgement record to be insufficient to grant summary judgment to either the Clinic or the government under this interpretation, remanding the case for further proceedings (which presumably means a trial unless the parties settle).

Lloyd Mayer

Coverage: Law360 (sign-up required).