Pottstown Sch. Dist. v. Montgomery Cty. Bd. of Assessment Appeals

Public Charity Real Estate Tax Exemption; Application of “operates entirely free from private profit motive” criteria of HUP Test

Pottstown Sch. Dist. v. Montgomery Cty. Bd. of Assessment Appeals, 289 A.3d 1142 (Pa. Cmwlth. 2023), allocatur granted Oct. 16, 2023, appeal docket 95 MAP 2023

Pursuant to article VIII, section 2(a)(v) of the Pennsylvania Constitution, the General Assembly may by law exempt from taxation “[i]nstitutions of purely public charity….” Pa. Const. art. VIII, § 2(a)(v). In order to implement article VIII, section 2(a)(v), the General Assembly enacted the Institutions of Purely Public Charity Act, commonly known as Act 55. In order to qualify for an exemption as an institution of purely public charity, an entity must meet both the constitutional requirements set forth in Hospital Utilization Project v. Commonwealth, 507 Pa. 1, 487 A.2d 1306 (1985), known as the HUP test, and the statutory requirements of Act 55. In order to qualify for an exemption under any law enacted pursuant to article VIII, section 2, an entity must show that it is an institution of “purely public charity” by satisfying the five criteria of the HUP test by showing that the entity:

(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.

HUP, 487 A.2d at 1317.

The final criterion of the HUP test, operating “entirely free from private profit motive,” is a central issue in this case, which arises from appeals filed by Pottstown School District (School District) from a decision of the Court of Common Pleas of Montgomery County (trial court) granting real property tax exemptions to Pottstown Hospital, LLC (Hospital) in several consolidated cases. Commonwealth Court summarized the factual background as follows:

In 2017, Reading Health System, now known as Tower Health, LLC (Tower Health), bought several for-profit hospital facilities and related properties formerly owned by Community Health Systems, a for-profit entity, in Montgomery and Chester Counties. Trial Ct. Op. 10/8/21 at 1-2. Tower Health, a limited liability company (LLC) with federal nonprofit status under 26 U.S.C. § 501(c)(3), created a new LLC to run each of the purchased hospital facilities as a nonprofit entity. Id. at 2. Tower Health is the sole member of each new LLC. Id. at 3. Hospital is one of the new LLCs and operates a hospital facility in Montgomery County. Id.

Hospital is a community acute care hospital providing a full range of health services. Trial Ct. Op. 10/8/21 at 4. Hospital also provides education and training to medical residents, participates in clinical research, and engages in community outreach programs. Id. at 5. Hospital operates under Tower Health’s 501(c)(3) certification and is exempt from state sales and use tax as a charitable entity. Id. Tower Health adopts a budget for Hospital and limits the expenditures Hospital can make without Tower Health’s approval. Id. at 5-6. Hospital’s revenues are placed in Tower Health’s checking account. Id. at 6. For fiscal year 2018, Hospital had a net income surplus of $12,687,723, which was reinvested in furtherance of Hospital’s mission. Id. For fiscal years 2019 and 2020, Hospital had deficits in net income of $34,116,689 and $75,684,171, respectively. Id. at 8.

Slip op. at 2. The Montgomery County Board of Assessment Appeals (Board) granted Hospital’s application for a property tax exemption as a nonprofit entity for tax years 2018 through 2021. The School District appealed the Board’s decision to the trial court. Commonwealth Court summarized the trial court’s analysis as follows:

The trial court concluded that Hospital met all five criteria of the HUP test. First, regarding a charitable purpose, the trial court found Hospital benefits the public from both an educational and a social standpoint. Trial Ct. Op. 10/8/21 at 28. Hospital provides education to its medical residents and the community at large and operates to prevent and treat disease and injury. Id. Hospital has an open admission policy and accepts patients regardless of their ability to pay. Id. at 27. Therefore, the trial court determined that since tax year 2018, Hospital has advanced a charitable purpose, and the fact that Hospital accepts payments from Medicare and Medicaid or from those patients who are able to pay did not require a different conclusion. Id.

Second, regarding provision of a “substantial” percentage of services gratuitously, the trial court again relied on Hospital’s written financial assistance policy of providing medically necessary care without regard to patients’ ability to pay. Trial Ct. Op. 10/8/21 at 28. The court found that Hospital donated or gratuitously rendered care in fiscal years 2018 through 2020 in the amounts of $15,607,753, $27,801,908, and $43,106,410, respectively, including costs for charity care, bad debt write-offs, and undercompensated care provided to patients on Medicare or Medicaid. Id. at 27-28. For fiscal years 2018-2020, Hospital’s donations to the community exceeded its net income, and approximately 46-47% of patients paid less than the full cost of their care. Id. at 28. Therefore, the trial court concluded that “[u]nder the totality of the circumstances, Hospital has made a ‘bona fide effort to service primarily those who cannot afford the usual fee,’ ” and consequently, Hospital donated or rendered gratuitously a substantial portion of its services. Id. at 29.

Third, regarding benefits to persons who are legitimate objects of charity, the trial court once again pointed to Hospital’s open admission policy. Trial Ct. Op. 10/8/21 at 30. Further, the court observed that “people whose costs are only partially covered by Medicaid payments are manifestly legitimate objects of charity and people who cannot afford to pay.” Id. at 29 (quoting St. Margaret Seneca Place, 640 A.2d at 384) (additional quotation marks omitted).

Fourth, regarding relief of some of the government’s burden, the trial court found that Hospital regularly accepts Medicare and Medicaid payments that are less than the costs of services rendered to the covered patients. Trial Ct. Op. 10/8/21 at 30. The court reasoned that without Hospital, the government would have to fund the full costs of such services. Id. Therefore, the trial court concluded that Hospital’s acceptance of less than full payment relieves the government of some financial burden. Id.

Fifth, regarding operations free from private profit motive, the trial court found Hospital’s surplus revenue in 2018 was reinvested into Hospital to improve services. Trial Ct. Op. 10/8/21 at 31. There were deficits in 2019 and 2020. In all three fiscal years, Hospital’s uncompensated services exceeded its net income. Id.

Regarding executive compensation, the trial court found that such compensation paid by Tower Health, as well as Hospital, was relevant to this factor of the HUP test. Trial Ct. Op. 10/8/21 at 32. The trial court described the high compensation of Tower Health’s executives as “eye popping,” but nevertheless determined it was reasonable because the trial court concluded it was bound by this Court’s decision in Phoebe Services. Trial Ct. Op. 2/3/22 at 24-26.

In Phoebe Services, we concluded the HUP test was not violated where an “incentive pay plan [was] typical of other healthcare nonprofits, represent[ed] fair market value for the services provided, and [was] not directly tied to the financial status of the nonprofit” and “[t]he compensation scheme [was] designed to stay competitive within the market, and retain employees rather than lose the employees to competitors ….” 262 A.3d at 671. This Court reached that conclusion even though the base salaries of some executives were between the 75th and 90th percentile of market salary levels and the bonus and incentive pay for the chief executive officer (CEO) could exceed 25% of base compensation. Id. at 671.

Relying on Phoebe Services, the trial court here concluded executive compensation of both Hospital and Tower Health met the HUP test because salaries did not exceed the 90th percentile. Trial Ct. Op. 10/8/21 at 22 & 25-26. The trial court reached this conclusion even though 40% of incentive pay was based on financial performance. See id. at 13.

Concluding that all factors were met, the trial court determined that Hospital met the HUP test requirement to operate entirely free from private profit motive. Trial Ct. Op. 10/8/21 at 33. Accordingly, the trial court concluded Hospital met the constitutional requirements for a tax exemption as a “purely public charity.” Id.

Slip op. at 15-17. The School District appealed to Commonwealth Court.

Commonwealth Court disagreed with the trial court’s reliance on Phoebe Services, finding that In re Dunwoody Vill., 52 A.3d 408, 423 (Pa. Cmwlth. 2012) in which Commonwealth Court found the exemption did not apply where “a substantial percentage” of executive compensation was based on the institution’s financial or marketplace performance was “more analogous and persuasive than Phoebe Services in this case,” reasoning that:

In Dunwoody Village, this Court explained that the requirements of the HUP test are separate from those of Act 55. 52 A.3d at 422 (explaining that “an entity seeking a tax exemption as an institution of purely public charity must first meet the constitutional requirements of the HUP test before the question of whether it satisfies the corresponding statutory criteria in act 55 can be addressed”) (citing Mesivtah Eitz Chaim)). For example, Act 55 requires an applicant for a tax exemption to demonstrate, in part, that employee compensation “is not based primarily upon the financial performance of the institution.” Dunwoody Vill., 52 A.3d at 421 (quoting Section 5(c)(3) of Act 55, 10 P.S. § 375(c)(3)) (additional quotation marks omitted). However, the HUP test, which must be satisfied first, may preclude a tax exemption even though less than the majority of an employee’s compensation is based on the institution’s financial performance. Dunwoody Vill., 52 A.3d at 422.

The executive compensation at issue in Dunwoody Village “included incentives related to [the institution’s] financial or marketplace performance,” such that compensation was based “in part” on the institution’s annual financial performance. 52 A.3d at 422-23. This Court observed that the CEO’s maximum incentive bonus was 24% of salary and the chief financial officer’s was 18-19%. Id. at 423. We described this as “a substantial percentage” of compensation that was based on financial performance. Id. Notably, there was no discussion in Dunwoody Village stating how much of the bonus incentive was tied to financial performance rather than other criteria. See id. Nonetheless, we affirmed the lower court’s decision that the institutional taxpayer “failed to establish that it operate[d] entirely free from private profit motive.” Id. (additional citation omitted).

Phoebe Services concerned an application for an exemption from a business privilege tax imposed by a city ordinance. At issue was whether the nonprofit taxpayer was a “business” within the meaning of the ordinance, which defined that term as “any activity carried on or exercised for gain or profit in the [c]ity.” 262 A.3d at 663. The city argued that the taxpayer operated with a profit motive because its executive compensation included bonuses based on financial performance. Id. at 666. This Court found cases analyzing the HUP test’s “private profit motive” criterion, including Dunwoody Village, to be instructive. Id. at 669. Contrary to the city’s argument, however, we found that the executive compensation in Phoebe Services was “not directly tied to the financial status of the nonprofit.” Id. at 671. Thus, Phoebe Services is distinguishable from Dunwoody Village in this regard.

Accordingly, we find Dunwoody Village more analogous and persuasive than Phoebe Services in this case. We do not accept the suggestion that the executive salaries at issue must be deemed reasonable merely because they do not exceed the 90th percentile for such salaries. We agree with the trial court’s characterization of the Tower Health executive salaries at issue as “eye popping,” and we also conclude that tying 40% of the bonus incentives to Hospital’s financial performance is sufficiently substantial to indicate a private profit motive, contrary to the HUP test.

Slip op. at 18-20. Additionally, Commonwealth Court found that the record lacked evidence to establish the reasonableness of the fees paid to Tower Health, therefore Hospital could not satisfy its burden of showing that it operated entirely free from a profit motive under the HUP test.

The Pennsylvania Supreme Court granted allocatur as to the following issues:

(1) Whether the Commonwealth Court erred by holding that Pottstown Hospital, LLC, offered substantial executive compensation based upon the financial performance of the institution, thereby precluding it from establishing that it was operating entirely free from private profit motive to qualify as a purely public charity entitled to real estate tax exemption under the standard set forth in Hospital Utilization Project v. Commonwealth (“HUP”) [507 Pa. 1], 487 A.2d 1306, 1317 (Pa. 1985).

(2) Whether the operation of entities related to Pottstown Hospital, LLC, is relevant to a determination of whether it qualifies as a purely public charity under the HUP test.

For more information, contact Kevin McKeon or Dennis Whitaker.