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District Court Invalidates Regulation Defining Educational Organizations

(Parker Tax Publishing August 2019)

A district court held that Reg. Sec. 1.170A-9(c)(1), which provides that an organization qualifies as an educational organization under Code Sec. 170(b)(1)(A)(ii) only if education is the organization's primary function and its noneducational activities are merely incidental to its educational activities, is invalid since it does more than the law allows because it adds requirements - the primary-function and merely-incidental tests - Congress intended not to include in the statute. Applying Chevron U.S.A., Inc. v. Natural Resources Defense Council, 467 U.S. 837 (1984), the court concluded that by omitting those requirements from Code Sec.170(b)(1)(A)(ii) while including a similar test elsewhere in the same statute, Congress unambiguously chose not to include those tests. Mayo Clinic v. U.S., 2019 PTC 295 (D. Minn. 2019).


Mayo Clinic (Mayo) is a Minnesota nonprofit corporation and a Code Sec. 501(c)(3) organization. Mayo is the parent organization of several hospitals, clinics, and the Mayo Clinic College of Medicine and Science. The College is comprised of five distinct medical schools that offer M.D., Ph.D., and other degrees, as well as residencies, fellowships, and continuing medication.

After conducting an audit, the IRS in 2009 asserted that Mayo owed tax on certain income that it received from partnerships. The IRS concluded Mayo was not entitled to a tax exemption with respect to this partnership income because, in its view, Mayo was not an educational organization under Code Sec. 170(b)(1)(A)(ii). In 2013, the IRS issued a Technical Advice Memorandum confirming its position that Mayo did not qualify as an educational organization. The IRS concluded that Mayo's primary function was not formal instruction. Mayo paid the disputed taxes and, in 2016, filed a lawsuit seeking a refund of $11,501,621.

Tax exempt charitable organizations can exclude from their unrelated business income (UBI) certain types of passive income - such as income from dividends, interest, and real-property rents. This passive-income exclusion is generally what allows a tax-exempt organization to avoid incurring unrelated business income tax on the dividends and interest that it earns on its endowment. But there is an exception to this exclusion: if the passive income is earned using borrowed money, then the amount that is excluded from UBI is reduced. And this exception, too, has an exception: when the passive income comes from debt-financed real property, the income can be excluded from UBI if the organization is a qualified organization under Code Sec. 514(c)(9)(C). Included among the qualified organizations is an organization described in Code Sec. 170(b)(1)(A)(ii).

Code Sec. 170(b)(1)(A)(ii) describes an educational organization which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of students at the place where its educational activities are regularly carried on (the faculty-curriculum-student-place requirements). In Reg. Sec. 1.170A-9(c)(1), the IRS defined an educational organization as one that meets the faculty-curriculum-student-place requirements, but includes two additional requirements that do not appear explicitly in the statute. Those requirements are the "primary function" requirement and the "merely incidental" test. Under the regulation, an organization cannot qualify as an educational organization unless education is the organization's primary function and its noneducational activities are merely incidental to its educational activities.

The government conceded that Mayo met the faculty-curriculum-student-place requirements in Code Sec. 170(b)(1)(A)(ii). But it argued that Mayo is nonetheless not an educational organization because its primary function is healthcare, not education, and even if that were not so, that Mayo's healthcare activities are not merely incidental to its educational activities. Mayo, on the other hand, described its educational and patient-care activities as essential to each other and inextricable. Mayo also contended that the IRS had exceeded its authority in adding the primary function/merely incidental tests because, under Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), Congress had the chance to add those tests to the statute and unambiguously elected not to.


The district court awarded summary judgment to Mayo because it found that the government's position that Mayo was not entitled to the refund it sought was premised entirely on Mayo's alleged inability to satisfy the requirements in Reg. Sec. 1.70A-9(c)(1), and the court concluded that those requirements exceeded the bounds of authority given under Code Sec. 170(b)(1)(A)(ii).

Applying Chevron, the court concluded that the regulation did more than the law allows because it added requirements that Congress intended not to include in the statute. The court explained that Chevron requires courts to (1) ask whether Congress has directly spoken to the precise question at issue and, if not, (2) determine whether the agency's answer is based on a permissible construction of the statute. The precise issue, in the court's view, was whether Code Sec. 170(b)(1)(A)(ii) is silent or ambiguous with respect to the primary function and merely-incidental requirements in the regulation.

The court agreed with Mayo that Congress unambiguously chose not to include a primary function requirement in Code Sec. 170(b)(1)(A)(ii) and the Treasury Department exceeded the bounds of its statutory authority when it issued the primary-function requirement in Reg. Sec. 1.170A-9(c)(1).

The court also concluded that Congress decided not to include the merely-incidental test in Code Sec. 170(b)(1)(A)(ii) because "merely incidental" was another way of saying that an organization's educational activities must be its primary purpose or function. The court said that the regulation identifies only one purpose - educational activities - to which all other activities must be merely incidental. In the court's view, requiring all noneducational activities to be merely incidental to the educational activities means an organization could have no non-incidental or primary purpose other than education to qualify as an educational organization. The court also noted that this conclusion was supported by the plain meanings of the relevant terms as well as IRS revenue rulings.

For a discussion of Code Sec. 501(c)(3) organizations, see Parker Tax ¶60,502.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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