On May 30, the Pennsylvania Supreme Court issued its long-awaited opinion in Pottstown School District v. Montgomery County Board of Assessment Appeals. In a 5-2 decision, the court held that Pottstown Hospital in Montgomery County (Hospital) qualified for real estate tax exemption as an “institution of purely public charity.”

This major decision backing tax exemption in an era of consolidation in the health care industry will allow hospitals to survive, thrive and provide essential medical care to the communities they serve. The Pottstown decision will be a valuable resource that hospitals and other nonprofits can rely on as they structure their employee compensation plans as part of their overall strategies to provide essential charitable services to their communities. Representing the Hospital, the Stevens & Lee team presented key arguments that helped secure this important victory for the client and the wider community of nonprofits across the Commonwealth of Pennsylvania.

In Pennsylvania, entities are exempt from real estate taxes if they qualify as “purely public charities” under Article VIII, Section 2(a)(v) of the Commonwealth’s Constitution. To be exempt under this constitutional provision, an entity must satisfy the elements of a multi-factor test developed by the Supreme Court in its decision in Hospital Utilization Project v. Commonwealth, 487 A.2d 1306 (Pa. 1985) (HUP). An entity also must prove entitlement to tax exemption under two separate statutory tests.

In the Pottstown case, the tax assessment board and trial court found the Hospital exempt. But then the Commonwealth Court held the opposite, concluding that the Hospital did not qualify as a “purely public charity.” The court decided the Hospital did not operate “entirely free from private profit motive” under the fifth prong of the HUP test. According to the court, compensation and financial performance incentives paid to executives of the Hospital and its parent entity, Tower Health, showed a disqualifying “private profit motive.” The Commonwealth Court also found that the Hospital failed to show the reasonableness of the fees it paid to the parent for management and administrative services.

The Commonwealth Court’s surprising decision posed a significant threat to many kinds of nonprofits — not just those in the health care space. It created worry about compensation plans and management structures for nonprofits writ large, putting them at risk of losing their exempt status and having to devote funds to tax payments that otherwise could be put toward their nonprofit purposes.  

Thankfully, the Supreme Court reversed and reinstated Pottstown Hospital’s tax exemption. It explained that “only the salaries of the executives of a corporation seeking the tax exemption, and the net impact the payments of fees by that organization to a parent or affiliate corporation has on its own ability to fulfill its charitable mission, are relevant under the HUP test.” The Supreme Court announced that the “size of compensation” paid to executives and “the amount of the management fees” the Hospital paid to the parent “are insufficient by themselves to render the Hospital ineligible for a tax exemption.”

The Supreme Court reiterated that the fifth prong of the HUP test, relating to “private profit motive,” requires a fact-specific examination of the “reasonableness” of executive compensation. The court offered helpful guidance for future cases by listing some factors that may be considered when reviewing an executive’s compensation as part of the “private profit motive” analysis:

• Compensation paid by similar organizations for comparable positions
• The organization’s need for the individual’s services
• The individual’s background, education, responsibilities, experience and training
• Whether the compensation resulted from arm’s-length bargaining
• The size and complexity of the organization
• The individual’s prior compensation arrangement
• The individual’s performance
• The relationship of the individual’s compensation to the compensation of other employees at the organization
• The amount of time the individual devotes to the position

The Supreme Court also clarified that “there is no fixed percentage of total executive compensation based on financial performance” that will automatically “render a particular compensation structure unreasonable.”

The Supreme Court’s Pottstown decision is a pivotal milestone for nonprofits in Pennsylvania. It confirms the ability of all nonprofits to pay reasonable, fair market compensation — including economic incentives — to attract and retain top executive talent without running the risk of losing tax-exempt status. The court’s decision guides nonprofits and taxing bodies alike by explaining that only the executive compensation of the entity seeking tax exemption is relevant to whether that entity qualifies as a “purely public charity.” And the court’s opinion reaffirms that nonprofits will not lose tax exemption by contracting with parent or affiliated companies for administrative services — a key, economically-efficient ruling for entities in consolidated industries like health care.

Pottstown Hospital was represented by Stevens & Lee attorneys Thomas I. Vanaskie, Thomas A. Bowen, Karl S. Myers and Peter J. Adonizio, Jr., as well as Myers, Brier & Kelly, LLP attorneys Daniel T. Brier and Donna A. Walsh.