Understanding the intricate nuances of tax exemptions for nonprofit organizations is crucial for those involved with tax exempt clients. A recent decision from the United States Court of Appeals for the Eighth Circuit, Mayo Clinic v. United States (Case No. 23-2246), provides significant clarity, particularly concerning the definition of an "educational organization" under Internal Revenue Code (IRC) § 170(b)(1)(A)(ii) and its implications for unrelated business income tax (UBIT) exemptions. This article delves into the factual background, the taxpayer’s request for relief, the court’s detailed legal analysis, and its application to Mayo Clinic’s operations, culminating in the court’s conclusions.

Factual Background and the Taxpayer’s Claim

Mayo Clinic, a Minnesota nonprofit corporation, holds tax-exempt status under IRC § 501(c)(3). The core of this case involves Mayo’s refund claim for substantial UBIT imposed by the Internal Revenue Service (IRS). The IRS assessed Mayo $11,501,621 in unpaid acquisition indebtedness UBIT for tax years 2003, 2005-2007, and 2010-2012, based on the acquisition indebtedness of property held by Mayo to produce income. Mayo paid the assessed amount and initiated this refund action in September 2016.

The UBIT, expanded by the Tax Reform Act of 1969 to include amounts determined by the acquisition indebtedness of debt-financed property, is generally imposed on 501(c)(3) organizations. However, the specific UBIT provision at issue, IRC § 514(c)(9)(A), (C)(i), provides an exception for debt incurred by a "qualified organization" in acquiring or improving real property. Qualified organizations are defined to include 501(c)(3) educational organizations as described in IRC § 170(b)(1)(A)(ii). This section specifically refers to 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".

The Contested Tax Exemption and Prior Litigation

The IRS initially concluded that Mayo’s acquisition indebtedness was not exempt because Mayo, during the Tax Years, did not meet the definition of a § 170(b)(1)(A)(ii) qualified organization as defined in Treasury Regulation § 1.170A-9(c)(1). This regulation specified that an organization’s "primary function" must be "the presentation of formal instruction," and its noneducational activities must be "merely incidental to [its] educational activities".

The district court initially granted Mayo summary judgment, deeming Mayo an educational organization under § 170(b)(1)(A)(ii) and finding Treasury Regulation § 1.170A-9(c)(1) invalid for adding the "primary function" and "merely incidental" requirements. However, the Eighth Circuit, in Mayo Clinic v. United States, 997 F.3d 789 (8th Cir. 2021) (Mayo I), reversed this invalidation "to the extent it is not inconsistent with IRC § 170(b)(1)(A)(ii)". Mayo I concluded that it is valid to interpret § 170(b)(1)(A)(ii) as requiring a qualifying organization’s primary purpose to be "educational" and its noneducational activities to be merely incidental to that primary purpose, given the settled judicial interpretation of "organized and operated exclusively" in IRC § 501(c)(3). However, Mayo I agreed that the Treasury Regulation’s specific requirement that the "primary function must be the presentation of formal instruction" lacked a long history of congressional acceptance and was an "unreasonable condition".

Because the record in Mayo I did not definitively establish whether Mayo’s overall purpose and operations were "exclusively" educational, the case was remanded for further proceedings. The appellate court noted the "inextricably intertwined" nature of Mayo’s medical and educational purposes as an academic medical center. It also emphasized that "the presence of a single non-educational purpose, if substantial in nature, will destroy the UBIT exemption regardless of the number or importance of truly educational purposes," citing Better Bus. Bureau of Wash., D.C. v. United States, 326 U.S. 279, 283 (1945).

On remand, after a week-long bench trial, the district court concluded that "primary" in this context means "substantial". It found that Mayo had a substantial educational purpose and no substantial noneducational purpose during the Tax Years because its educational functions are "inextricably intertwined" with its clinical and research functions. The court determined that Mayo uniquely integrates education, clinical practice, and research across all operations, making education a "substantial part of Mayo’s reason to exist". Consequently, the district court granted Mayo judgment for the full refund amount. The United States appealed this conclusion.

Key Legal Interpretations on Appeal

The government’s appeal raised two primary issues: how to measure educational versus noneducational activity, and the degree to which education must be Mayo’s primary purpose. The government contended that "primary" means "principal or most important purpose," while Mayo argued it only needed to be "substantial".

Interpreting "Primary Purpose"

The appellate court examined the meaning of "primary" in the context of an educational organization’s purpose. The district court reasoned that its interpretation of "primary" as "substantial" was strongly supported by the Supreme Court’s decision in Board of Governors of Federal Reserve System v. Agnew, 329 U.S. 441 (1947). In Agnew, the Court determined that a firm was "primarily engaged" in underwriting, even though underwriting comprised at most 39% of its gross income. The Supreme Court stated that while "primary" can mean "first, chief, or principal," other accepted meanings include "essentially" or "fundamentally," meaning an activity can be "primary" if it is "substantial". The Agnew court further reasoned that interpreting "primary" otherwise would lead to absurd results, where a firm specializing in multiple lines of business would not be "primarily engaged" in any, despite substantial activity. This interpretation was also deemed "more consonant with the legislative purpose" of the Banking Act.

The Eighth Circuit agreed that the reasoning of Agnew applies to this case, noting the difficulty in pinpointing a singular, predominant activity for Mayo, given its inextricably intertwined education, patient care, and research functions. The court found that Mayo’s reading of "primary" as "substantial" better aligns with the broad view of a tax-exempt educational purpose found in Treasury Regulations, specifically § 1.501(c)(3)-1(d)(3)(i) and (ii), which provide examples such as museums, zoos, planetariums, and symphony orchestras as "educational organizations". The court observed that symphonies are considered "entertainment as much as they are considered educational," yet they qualify. This broad view reflects the judicial consensus that "exclusively" in § 501(c)(3) should not be interpreted literally to achieve the underlying purposes of income tax exemptions and charitable deductions.

The government argued that this interpretation disregarded the "merely incidental" limitation in Treasury Regulation § 1.170A-9(c)(1), implying educational activities must be predominant. The government cited Malat v. Riddell, 383 U.S. 569 (1966), where the Supreme Court interpreted "primarily" to mean "of first importance" or "principally" in the context of real estate sales. However, the Eighth Circuit agreed with the district court that Malat is distinguishable because it concerned differentiating between two possible tax treatments (ordinary income vs. capital gains). An organization like Mayo, the court clarified, can have more than one substantial function (medical education and patient care) and other noneducational functions (like administrative operations) that are merely incidental to education. Ultimately, the court concluded that the district court did not err in interpreting "primary" as "substantial". Even if the government’s stricter interpretation were adopted, the court found that Mayo’s substantial patient care activities are not "noneducational" due to their careful integration with education.

Assessing "Substantial, Noneducational Purpose"

The second major issue was whether Mayo has a substantial, noneducational purpose that would destroy its UBIT exemption. The government argued that Mayo’s nationwide hospital network and extensive patient care activities disqualify it. The government invoked Better Business Bureau, where the Supreme Court found the Bureau’s important, if not primary, pursuit was to promote a profitable business community, making the exemption unavailable.

The Eighth Circuit, however, distinguished Better Business Bureau. In Mayo I, the court had already clarified that the overlap of educational purposes with other charitable categories does not disqualify an organization unless a substantial noneducational purpose exists. The district court, supported by extensive trial evidence, concluded that while "patient care is certainly [a] substantial [purpose,] it is not noneducational at Mayo". The evidence did not identify a "substantial" clinical practice function that did not further the goal of providing training and education to Mayo’s students. The appellate court affirmed this, stating that its decision in Mayo I did not foreclose the conclusion that a § 501(c)(3) charitable organization with a hybrid function that furthers another charitable purpose as well as education can still qualify as an "educational organization". The disqualifying factor is if the other charitable purpose is substantial and unrelated to the educational functions.

Application of Law to Mayo Clinic’s Operations

The court reviewed the district court’s factual findings regarding Mayo’s integration of its functions. The district court found that Mayo’s organizational structure, governance, and mission statements consistently reflect the principal role of education. Mayo’s 1919 Deed of Gift placed "the promotion of medical, surgical and scientific learning, skill, education and investigation" at its core. Mayo’s Articles of Incorporation stated it is "organized and shall be operated exclusively for charitable, educational, and scientific purposes". Its bylaws preamble noted that earnings should be used for "better care of the sick, medical education for better trained doctors, research and the general welfare of the public".

Operationally, Mayo’s extensive educational offerings and day-to-day activities demonstrate its substantial educational purpose. Its five schools boast stellar accreditation records and high board certification rates. Crucially, students are taught not only in classrooms but "anywhere that there’s patient care," including operating rooms and hallways, with Mayo physicians expected to participate in education and obtain academic rank. The court found that Mayo’s facilities are predominantly used for educational purposes, and its medical treatment and research nearly always serve an educational purpose, even when student involvement increases healthcare costs. Mayo also significantly invests in its schools, maintaining a high volume of patients with complex diseases (e.g., flying in patients from Mongolia for cardiovascular surgery fellows at an annual cost of $5 million) to meet educational requirements. Financially, Mayo’s educational and research activities operated at a significant net financial loss during the Tax Years, spending more on these areas than it earned from patient care, and allocating a substantial portion of its endowment to education.

The district court’s conclusion that Mayo has no substantial, noneducational purposes rested on the finding that Mayo "uniquely integrates education, research, and clinical practice across all of its operations". Its educational functions are "inextricably intertwined with its other functions". The court explicitly stated that patient care, while substantial, is not noneducational at Mayo due to this careful integration. Even Mayo’s expansion to Florida and Arizona and its acquisition of the Mayo Clinic Health System (MCHS) network were found to improve educational offerings by broadening the patient base to include less common conditions, with education occurring at almost every MCHS site. Over 97% of Mayo’s physicians hold academic rank.

Judicial Precedent and Regulatory Guidance

The court drew on analogous cases to support its position. It cited Living Faith, Inc. v. Commissioner, 950 F.2d 365 (7th Cir. 1991), which stated that a single activity may be carried on for more than one purpose, and a primary activity constituting a trade or business does not disqualify an organization from § 501(c)(3) status if it furthers an exempt purpose. Unlike Living Faith, whose religious functions were "peripheral and incidental to the substantial commercial purpose" of its restaurants, Mayo "joined and integrated" its patient care with its educational offerings.

The court distinguished Redlands Surgical Services v. Commissioner, 113 T.C. 47 (1999), aff’d, 242 F.3d 904 (9th Cir. 2001), where a nonprofit operating a surgical center through a partnership was denied exemption. In Redlands, the nonprofit "ceded effective control" to for-profit parties, which was not the case at Mayo, where no for-profit party controls its operations.

The Tax Court’s decision in Dumaine Farms v. Commissioner, 73 T.C. 650 (1980), also supported the district court’s analysis. In Dumaine Farms, an experimental farm qualified for exempt status despite selling crops because its commercial purpose (selling crops and timber) directly furthered its exempt purpose of demonstrating the economic feasibility of environmental conservation, with profits financing other conservation activities. Similarly, the district court determined that the purpose of Mayo’s patient care activities is to advance its educational purposes, rendering them not "noneducational".

The court further bolstered its argument by referencing the broad language of Treasury Regulation § 1.501(c)(3)-1(d)(3)(i), which defines "educational" to include instruction for developing individual capabilities or instructing the public on useful subjects. It also considered a 1969 IRS letter ruling regarding the merger of the Associates of Mayo Clinic (which employed over 400 physicians and treated approximately 200,000 patients annually) into the Mayo Foundation. The IRS then determined that the Associates "contribute[d] importantly" to the Foundation’s "educational and scientific research purposes and is commensurate in size with those activities," and therefore the merger did not affect its § 501(c)(3) status. The court viewed this as "strong if not conclusive evidence" that Mayo’s integrated medical education, patient care, and research missions comprise the type of "similar organization" encompassed by Treasury Regulation § 1.501(c)(3)-1(d)(3)(ii).

The court concluded that although Mayo’s patient care is a substantial purpose, it is not "merely incidental" in the strict sense, but crucially, it is not "noneducational". Patient care at Mayo is not "an end in itself rather than merely a means of accomplishing a charitable goal".

The Court’s Affirmation and Its Implications

Finally, the government contended that Mayo is more appropriately categorized as a teaching hospital or medical research organization under IRC § 170(b)(1)(A)(iii), arguing that this category does not qualify for the § 514(c)(9)(C) UBIT debt-financed real property exception. The court rejected this, noting that the statute does not mandate an organization to qualify under only one § 170(b)(1)(A) category. The district court had already concluded that Mayo is an "educational organization" under § 170(b)(1)(A)(ii), and if that conclusion is sound, its potential qualification under another category is irrelevant. The court dismissed the government’s "parade of horribles" argument, which suggested that the decision would exempt all academic medical centers and teaching hospitals from § 514, emphasizing that the decision was based on the district court’s thorough, fact-based determination.

For the foregoing reasons, the judgment of the district court was affirmed.

Concurring Viewpoint

Judge Grasz concurred in the judgment but expressed a different view on the interpretation of "primary". While acknowledging that Mayo I upheld the Treasury Regulation’s "primary function" requirement, Judge Grasz stated that equating "primary" with "substantial" defies plain English and contradicts precedent requiring narrow construction of tax exemptions. Judge Grasz also found Agnew’s reasoning unpersuasive, as it reflected a purposive rather than textual approach to statutory construction. However, Judge Grasz ultimately concurred in the affirmation based on the district court’s alternative factual finding: even "[i]f ’primary’ meant ’most important,’ [it] would still find [as fact] that Mayo’s most important or principal purpose is education".

This case provides essential guidance for professionals advising nonprofit and tax-exempt organizations, particularly academic medical centers. It underscores that an organization’s interwoven activities, even substantial commercial ones like patient care, can be considered exempt activities if they are genuinely integrated with and further the organization’s primary exempt purpose. The distinction hinges on whether the ostensibly "noneducational" purpose serves as a means to, rather than an end in itself apart from, the educational mission.

Prepared with assistance from NotebookLM.