U. faces unprecedented challenge to tax-exempt status due to revenues from patent royalty-sharing

A suit filed against the University in 2011 has grown from a little publicized objection to tax breaks on a handful of University properties to a challenge against the justification for the University’s tax exemption as a whole. Experts say it could set a new precedent for the taxation status of universities — and the revenues they generate.

A group of four local residents challenge the University’s status as a property tax-exempt organization. The plaintiffs allege that the University doesn’t have a right to the town and state tax exemptions it receives because it collects and distributes profits generated by patented products developed in its research facilities.

Should the challenge succeed, it could alter the legal status of much of the University’s properties and operations, dramatically raising its annual tax bill.

This summer, the University sponsored a motion to have the case dismissed, which a state tax court judge denied in June. Afew weeks ago, the University hired one of the largest international law firms in the world, Simpson Thacher & Bartlett, LLP, to defend it.

The firm is no stranger to Princeton, having previously represented the University in the Robertson family lawsuit, when descendants of a family that had made major donations to theUniversity sued the schoolfor allegedly violating the terms of their gift. The University settled with the family in 2008, paying them almost $100 million.

Between 2006 and 2008, the University paid Simpson Thacher & Bartlett over $14 million in legal fees, according to IRS returns.

University Spokesperson Martin Mbugua declined to comment on the suit, explaining that the University does not discuss matters of pending litigation.

Patents and royalty-sharing

The University, like similar institutions around the country, profits from inventions developed in its research facilities. When products invented in the course of University research become commercial, the University often takes title to them, sharing royalties with the faculty or student inventors.

The biggest blockbuster patent has been the cancer-fighting drug Alimta, developed at the University in 2004. By 2012, it had brought the University $524 million in licensing income, according to Bloomberg News. In 2009, the University and the pharmaceutical company Eli Lilly sued a company attempting to manufacture a generic version of the drug for patent infringement.

In the current suit, the plaintiffs cite the profits and litigation from the Alimta patent as evidence that the University pursues research as a profit-making endeavor. They allege that because the University has used its license to bring in huge profits and has litigated aggressively to protect its license, it acts more like a private research partnership than a non-profit educational institution. This claim, which threatens the revenues generated by patents at universities nationwide, has brought national media attention to the suit.

When a researcher develops a product that may have commercial value, the University’s Office of Technology Licensing arranges to act as a partner to its inventors. The office charges licensing fees to manufacturers who use the patented product, and royalties from these fees are shared with inventors. In 2011, the University distributed about $35 million in royalties to its faculty, according to the plaintiffs.

The plaintiffs claim this function essentially commercializes the University’s research, therefore undermining its claim to non-profit status.

The case may go to trial as early as June. But experts consulted for this story were skeptical that the challenge would dismantle the University’s tax-exempt status altogether.

“I really don’t think the universities are going to lose their status as non-profit organizations,” Brookings Institution fellow Walter Valdivia, an expert on technology innovation policy, said. Should the challenge prevail, the precedent would more likely require universities to separate bodies like OTL — generally called technology transfer offices — from the rest of the school. Some institutions like the University of Wisconsin-Madison already do so, he explained.

“The universities are going to be forced to establish these technology transfer offices outside, at arm’s length from the university,” Valdivia explained. He speculated that the precedent would encourage more universities to administer these functions as a separate body, possibly open to taxation.

Plaintiff Ken Fields said that a scenario in which patent licensing was separated into a taxable entity is a possible road to settlement.

The case’s arguments center on the Bayh-Dole Act, a 1980 federal law that gives universities the right to share patent royalties. Prior to the law, inventions created with federal funding became the property of the federal government.

The University’s case brief defends the school by citing the fact that its actions are legal under Bayh-Dole. The plaintiffs’ argument doesn’t contest the legality of the University’s practices under Bayh-Dole, but instead contends that these operations undermine the tax-exemption, noting that the act itself uses the term “commercialization of patents” in describing these functions.

Bruce Afran, a Princeton-based lawyer representing the plaintiffs, argues that the University is acting no differently from any commercial pharmaceutical company. Afran is also involved in suits against the University challenging the move of Dinky Station.

The court’s ruling may come down to a careful examination of the University’s charter and whether it allows for the commercialization of patents, according to Gerald Barnett, the director of Research Technology Enterprise Initiative at the University of Washington. If the court to rule that it does not, he said, the University’s patent licensing office may become vulnerable to taxation.

A suit that has evolved

Whenthe original suit was filed in 2011, its plaintiffs were not even aware of the University’s practice of sharing patent royalties. Afran explained he didn’t discover the practice until he was preparing to reply to the University’s motion to dismiss the case in June.

“[Afran] looked on the University website and came across profit-sharing, and that set off an alarm,” Fields said. “If we had known about the profit-sharing, we wouldn’t have even filed against the buildings.”

Fields is a retired math professor who worked at Rider University. His son is a post-doctoral researcher in biophysics at the University of California in San Francisco.

“My son’s a scientist. He doesn’t know why I’m doing this,” Fields said. “He’s afraid that any judgment against private research institutions will affect funding for science.”

The suit is funded by a trust left by a friend of his, an attorney named Eleanor Lewis who lived in the town of Princeton and died in 2010. She left her trust, the product of earnings from her law practice, to benefit causes “in the public interest,” Fields explained. He and the other plaintiffs began conceiving of the case against the University with Lewis while she was still alive.

Fields declined to disclose the amount of the trust.

“We’ve got enough money to carry this through,” he said. “If we don’t do anything else, we'll at least see this case through.”

If there are funds remaining after the suit against the University, Fields added, the plaintiffs hope to challenge the tax-exempt status of religious institutions.

Some tax experts second Fields’ position that universities ought to be taxed. James Miller, an economics professor at Smith College, said he would advocate taxing all non-profit institutions.

“Taxes are pretty much always harmful to organizations, but you can minimize the social harm of a tax if you spread it out,” Miller said. “The real question is: should we lower taxes on other organizations and tax Princeton, or have higher taxes on other organizations and not tax Princeton?”

The University’s tax bill

Most of the University’s property is exempt from taxation due to its non-profit status. Still, the school pays about $10 million a year in taxes on its non-exempt properties, such as parking lots and some graduate student housing.

Should the court find that particular buildings do not qualify for exemption, individual properties may be added to the University’s tax rolls. If all the 19 properties currently being challenged were to lose their exemption, the University’s annual tax bill would rise by roughly $2.5 million, according to town tax records.

But if the court were to find that the University’s profits disqualified it from non-profit status altogether, it would lose tax exemptions on all of its property. This would add a whopping $30 million — which amounts to half the town’s operating budget — to its annual tax bill.

The plaintiffs’ main motivation for the suit is to allow the community to lower the tax burden on the rest of the community, Fields said. He and others initiated the suit after the 2011 tax revaluation significantly altered the tax bill of many local residents.

“Private universities do meaningful things, but that’s no reason to give them a free pass,” Fields said. “Basically, if they don’t [pay property taxes], then everybody else is doing it for them.”

Fields added that, if the town gained only the additional tax for the properties under challenge, he would still see it as a great success for the town. The approximately $2.5 million in additional taxes is roughly the amount that the University currently contributes through its voluntary payment-in-lieu-of-taxes, or PILOT, that it makes each year.

The University regularly renegotiates the amount of the PILOT with the town, as it will do this month. Were the University to owe that money in taxes, there would be little justification for the school to pay an additional sum in lieu of taxes.

Fields said the amount is perceived to be dependent on the town’s relationship with the University, and that abolishing it would give the town government more freedom.

“Basically everyone on town council is looking over their shoulders,” he said, saying that town leaders are fearful that the PILOT may be reduced if they antagonize the University. “Getting rid of the PILOT payment would be a major success as far I’m concerned.”

For University, reliance on old defender

After losing its motion to have the case dismissed in June, the University changed its legal representation from its prior tax law firm, McCarter & English, to Simpson Thacher and Bartlett, one of the world’s largest law firms. The firm has represented the University before, as well as international corporate clients such as Microsoft and JPMorgan Chase.

The University has filed a motion to allow for Mark Cunha of Simpson Thacher, a New York-licensed lawyer, to defend the University in N.J. court. Cunha also represented the University in the widely-publicized 2002 Robertson lawsuit, when the descendants of some of the University’s major donors alleged that the University had violated the terms of the family’s $35 million gift. At the time, the gift was the largest in the University’s history.

A Princeton-based lawyer, Jeffrey Gordon of the firm Archer & Greiner, will be listed as co-representation on the lawsuit.

Both Cunha and Gordon, as well as a representative from McCarter & English, deferred comment to University officials. University Vice President and Secretary Robert Durkee ’69 confirmed the facts of their employment but declined to comment further.

The town of Princeton is also named as a co-defendant in the suit, as the suit challenges the town’s property tax assessment. The town is represented by attorney Harry Haushalter, who deferred comment to Afran. The town neither opposes nor supports the suit, according to Afran.

The properties under challenge

The suit’s original complaint, filed in 2011, makes no mention of patent incomes or royalty-sharing schedules. Instead, it specifies University-owned buildings that plaintiffs allege are not used for functions necessary to the school’s educational mission.

These properties include Alexander Hall and McCarter Theatre, which the plaintiffs allege generate profits from ticket sales. McCarter is a non-profit professional theatre owned by the University. The plaintiffs also challenge Princeton University Press.

The complaint challenged the tax status of 19 properties, and the University’s motion did not universally dispute the challenges. Alexander Hall, Dillon Gymnasium, Prospect House, Princeton University Press, McCarter Theatre and 48 University Place were not included in the University’s motion to dismiss. Had the judge granted the motion, the suit would have continued, though would only challenge the undisputed properties.

Also challenged are Dillon Gymnasium and Prospect House, which the plaintiffs allege are not necessary for the University’s educational mission. The complaint describes Prospect House as a “private club owned and operated by the University.”

Most of the properties named in the complaint are used for University agencies, which plaintiffs allege are commercial in nature. Among these is the Office of the Dean for Research, which includes the Office of Technology Licensing.

A ruling on this issue would hinge on whether the court finds the operations at issue to be within the scope of the University’s tax-exemption, according to experts.

“The statutory criteria for a college is simply whether the organization claiming the exemption owns the property and is authorized to carry out the purposes for that exemption,” lawyer Richard De Angelis explained. De Angelis is a property tax attorney who blogs about New Jersey property tax law. “The burden is always on those claiming the exemption. In this case, it’s the school.”

Bruce Hopkins, a senior partner at Polsinelli, a national firm specializing in the representation of nonprofit, tax-exempt organizations, said he would be surprised if the court found in favor of the plaintiffs, which he said would require a very narrow interpretation of the school’s educational purpose.

“The whole concept of ‘educational’ would be a little bit more broadly interpreted than just classroom instruction. I mean, dismantling the university, saying all those other functions aren’t part of the university’s exempt purpose — that seems a rather narrow reading of the concept,” Hopkins said.

One of the properties named in the suit is McCosh Health Center, with the allegation that it is a “corporate health plan offered to employees, faculty and their families.” It states that the services provided by McCosh are not necessary to the University community, citing the existence of many other medical practices near the campus.

Another property named in the suit is the John MacLean House, which is the home of the University’s Alumni Association. Citing the fact that Alumni Council offers travel packages for alumni through its “Princeton Journeys” program, plaintiffs allege that the Council “is actually using Maclean House to operate an elite travel agency for alumni.”

The plaintiffs also challenge buildings that house services that they allege are commercial in nature, including Conference and Event Services, Dining Services and the Office of Information Technology.

Plaintiffs acknowledge that several of these buildings under challenge are partially used for educational purposes. Among its targets are East Pyne, New South and Frist Campus Center, each of which is acknowledged to contain classrooms. Plaintiffs cite the coffee bar in East Pyne, the administrative functions performed in New South and the various retail services offered in Frist.

The University’s reply brief states that none of these services are operated for commercial gain, and that any income received from them is directed to the school’s general fund. It notes that travel services for “Princeton Journeys” are arranged by an outside vendor.

Other properties under challenge include the private road Ivy Lane, the College Road West tennis court complex and the Charlton Street Substation, the University’s power-generating plant.

The original complaint also challenges 48 University Place, where independent publications such as The Daily Princetonian rent space from the school.

This suit is not the first to challenge the tax exemption of an organization in the area. In a 1961 suit, Princeton University Press — which is a separate entity from the University, but which the University acknowledges it has stakes in — lost its status as a non-profit in a challenge alleging that it was operated with the intention to profit.