In an interesting recent decision, International Schools Services Inc. v. West Windsor Township, N.J., the New Jersey Superior Court Appellate Division ruled that a not-for-profit organization whose purposes were to aid, promote and encourage educational organizations should lose its property tax exemption because its operation and use of the property was conducted for profit. This decision should make not-for-profits with affiliated for-profits or an ongoing working relationship with for-profits carefully scrutinize their activities with these for-profit entities.
The not-for-profit challenged property tax assessments for the 2002 and 2003 tax years on office condominium units it owned in the township. The not-for-profit argued the property was exempt under N.J.S.A. 54:4-3.6 as property actually used in the work of a not-for-profit corporation organized exclusively for the moral and mental improvement of men, women and children. Following the township’s denial of tax exemption, the not-for-profit appealed to the New Jersey Tax Court. The not-for-profit admitted that a portion of the property was leased to unrelated and related for-profit organizations, and did not claim an exemption for the portion of the property used for those purposes.
The NJ Tax Court found that the not-for-profit failed to satisfy the first of three prongs for its property tax exemption in New Jersey – to directly uplift the general public morally and mentally. On appeal, the NJ Superior Court Appellate Division reversed and remanded, finding that the not-for-profit did in fact meet the first-prong. The Tax Court thus had to determine whether the not-for-profit satisfied the second and third prongs for exemption (i.e., whether the not-for-profit actually used the property for the tax exempt purpose and whether the operation and use of the property were not conducted for profit). The NJ Tax Court ultimately found that the not-for-profit failed to satisfy the remaining two prongs, and entered judgment denying the exemption. The not-for-profit again appealed.
The court focused in on the third prong and its exception that exemption extend to cases where the exempt organization’s work is supported partly by fees received from the occupants, as long as the building is wholly controlled by and all of the income is used for the not-for-profit’s exempt purposes. The Tax Court found that the not-for-profit operated and maintained the property for the purpose of making a profit.
The court made the following observations to conclude that the not-for-profit’s property was operated for profit and thus not entitled to property tax exemption. Each of these observations is a factor to which not-for-profits should pay careful attention:
1. Subsidy. The court found substantial evidence demonstrating that the not-for-profit subsidized its related for-profit entities by activities conducted out of or by persons working at the property – i.e., it provided space to its affiliated for-profits at the subject property at rentals substantially below rates charged to other tenants and paid certain operating expenses for the space while the leases of other tenants were on a shared rental basis. This factor is extremely problematic because it tends to show that the related for-profit entities were being subsidized through either the not-for-profit’s operating income or from its surplus that would otherwise have been applied to the not-for-profit’s exempt purposes.
2. Loan. The court also found that the credit line to one of the for-profits came from the not-for-profit’s operations or surplus. Although the not-for-profit argued that the credit line was just another investment, the court noted that it was “an unsecured loan to a new entity that produced little income,” was consistently increased, and was a substantially different type of investment than the rest of the not-for-profit’s surplus. Moreover, five months after its repayment date, the loan had still not been repaid. This factor supported the court’s belief that the not-for-profit simply gave money to the for-profit without any inclination to have that money returned to it for its own exempt uses.
3. No Charge Back. The court found that the not-for-profit also used its profits to fund the affiliated for-profits by providing services to them without a “charge back” to them – e.g., the entities received, without charge, the benefit of two not-for-profit staff members’ services, the not-for-profit’s staff provided start-up accounting services for one of the for-profits and continued to maintain its books and records, and both for-profits’ federal tax returns for the subject period were prepared by a certified public accountant employed by the not-for-profit. Sharing employees can still work for not-for-profits without adverse results, but each employee must be compensated for the time spent on for-profit matters by the for-profit. If the not-for-profit provides any goods or services to a for-profit, no matter how insignificant, it should be reimbursed at cost for those services. If not, it is seen as a benefit bestowed upon a for-profit from that not-for-profit.
4. Promotion. The court concluded that the not-for-profit “intended to use its name to promote the joint profit-making ventures,” as evidenced by the press release announcing the joint venture’s formation with the not-for-profit as a partner although it was actually its affiliated for-profit that was the partner to the venture. The court also found that the not-for-profit promoted its affiliated for-profit’s financial products on its website. The fact that a not-for-profit is using its status or name to draw attention to a for-profit’s activities confers a benefit on a for-profit, and it may be in danger of being considered operating “for-profit.”
In short, all not-for-profits should be aware of and avoid any or a combination of: (i) the provision of professional services that are not “charged back;” (ii) below-market rents; (iii) unsecured loans that do not appear to have been timely repaid; (iv) lending their names and reputations to promote joint profit-making ventures; and (v) promotion of a for-profit’s products. These factors are potential downfalls for a nonprofit corporation.
Importantly, the court did not allow the not-for-profit to lose exemption on only a portion of the building because of its for-profit activities, as permitted by the statute and argued by the not-for-profit, but instead prevented property tax exemption entirely even though the court believed that the not-for-profit had a public benefit purpose and was operating to further that purpose. Accordingly, not-for-profits applying for property tax exemption in states that have partial exemption denials should carefully scrutinize their activities with for-profit entities to ensure that their properties would not be viewed as operating for profit, preventing them from claiming property tax exemption for the entire property.