The Tax-Exempt Entity's Property and a Lessee's Private Purpose

The real property at issue in Gourmet Dining comprised approximately 6½% of Kean University's 110,000-square-foot New Jersey Center for Science, Technology, and Mathematics building (NJCSTM Building). The NJCSTM Building was built with funds derived from the sale of tax-exempt bonds procured through the New Jersey Educational Facilities Authority (NJEFA), a governmental instrumentality authorized to arrange for the financing of construction projects for New Jersey educational institutions. The NJEFA owns the NJCSTM Building and leases it to Kean University, which uses it for the purpose of education. The university's Board of Trustees manages the building's operations.

The Board of Trustees resolved in June 2010 to task the Kean University Foundation with completing a restaurant project for the NJCSTM Building and finding a restaurateur to operate it. The Board of Trustees' resolution further stated that “a minimum of 10[%] of the restaurant's gross revenues annually [shall] be allocated for scholarship purposes within the [Kean University] Foundation.” The Kean University Foundation was granted the exclusive right to operate, manage and control the restaurant area NJCSTM Building, but it was permitted to “subcontract its Management Right to a manager with extensive experience and expertise in the management and operation of various restaurant and catering businesses, with [Kean] University's written consent.”

The Kean University Foundation entered into just such a subcontract with Gourmet Dining on Oct. 19, 2011. This Management Subcontract Agreement (MSA) called for Gourmet Dining to use its “extensive experience and expertise in the management and operation of various restaurant businesses” to “manage and control” the restaurant facility. Under the terms of the MSA, Gourmet Dining was to be responsible for “all expenses relating to the Facility during the Term, including but not limited to food costs and inventory expenses, liquor costs, supplies, salaries, Manager's salaries (if any), payroll expenses, taxes of every kind and nature (corporate taxes, sales taxes, federal, state and local taxes), equipment leases, advertising, licenses, and fees, insurance, maintenance and improvements, normal janitorial services and phone bills.” Gourmet Dining would reap the profits of the operation but would pay the Kean University Foundation “management fee[s]” of $250,000 per year for the first nine years and $500,000 in the 10th year, as well as 12.5% of the gross revenues (payable quarterly). Throughout the MSA, language like this indicated that Gourmet Dining was meant to manage the restaurant facility, not lease a piece of real estate in which to run its own restaurant. The restaurant that Gourmet Dining opened was called Ursino.

The Taxing Authority Sees a Private Business

With this background in mind, we move to Aug. 27, 2012, when Union Township sent Gourmet Dining a letter explaining that it would soon be receiving a tax bill “for the Ursino Restaurant facility at Kean University.” The township relied upon N.J.S.A. 54:4-2.3 to conclude that Gourmet Dining was a “lessee” of the restaurant portion of the NJCSTM Building; as such, the township's letter explained, it was “required to assess as taxable real property the portion of Kean University's Stem Building used and operated by Gourmet Dining, LLC as the Ursino Restaurant.” Taxes for the Ursino property were assessed at $50,000 a year for the land and $250,800 for improvements upon it.

Gourmet Dining complained to the court that because it was not a leaseholder of the restaurant space but merely the restaurant's manager, the property that Kean University had leased from the NJEFA must be treated as Kean University's. Kean University was joined as a party and agreed with Gourmet Dining — both of them arguing, among other things, that the MSA was not subject to local property taxation because it was not a lease.

Union Township moved for summary judgment, asserting that Gourmet Dining's interest in the property under the MSA was fundamentally a leasehold subject to local property tax under N.J.S.A. 54:4-2.3. Gourmet Dining continued to maintain that the MSA was not a lease, and also that it was entitled to tax immunity because it was actually using the premises in a manner that advanced the cause of education and that the restaurant operation was serving the public purposes of Kean University.

Was It a Lease?

In New Jersey, when a property is tax-exempt because it is, for example, part of a school or church, that tax-exempt status is not absolute if the property is leased out. In those cases, the leasehold taxing act, N.J.S.A. 54:4-2-3, is consulted to see whether the property remains non-taxable. It states:

When real estate exempt from taxation is leased to another whose property is not exempt, and the leasing of which does not make the real estate taxable, the leasehold estate and the appurtenances shall be listed as the property of the lessee thereof, or his assignee, and assessed as real estate.

(Before addressing the core issues, the court pointed out that even though Kean University and its affiliates are tax-exempt entities, if they leased out a portion of their premises to a party whose operations were not tax-exempt under the law, that portion of the real property used by the lessee would not become taxable — instead, the leasehold interest would become taxable.)

So, a preliminary question was, were the rights Gourmet Dining obtained under the contract a leasehold or something else?

A lease is a contract for exclusive possession of lands or other things for a prescribed term (a certain number of years, for life, at will, etc.), normally in exchange for rent or some other compensation. Black's Law Dictionary, 889 (6th ed. 1990). The lessor may retain some rights, but they must not be inconsistent with the rights granted to the lessee. If the agreement allows the lessor to cancel the agreement at will, it is a license and not a lease. However, whether the parties call the agreement a “license” or “lease” is not determinative; instead, the nature of the agreement controls. New Jersey's Supreme Court has stated in this regard:

[W]hether a particular agreement is a lease depends upon the intention of the parties as revealed by the language employed in establishing their relationship, and, where doubt exists, by the circumstances surrounding its making as well as by their course of operation under it …. And, in situations where the ambiguity or doubt gives rise to a factual question as to the intention of the parties, the burden is on the party asserting it to demonstrate existence of the lessor-lessee relationship. Moreover, in the resolution of ambiguity or doubt, absence of (1) a stipulation for rent as such, or other consideration regarded by the parties as constituting payment for the transfer of possession, and (2) a term; and presence of (1) limitations on exclusive possession and control of the premises, and (2) a right in the owner to revoke the permit to use at any time, are factors militating against the existence of a lease.

Thiokol Chemical Corp. v. Morris County Bd. of Taxation, 41 N.J. 405 (1964) (internal citations omitted).

Gourmet Dining and Kean University argued that the contract was not a lease, and was thus exempt from taxation under section 54:4-2-3, for a number of reasons. First, the contract did not contain the term “lease.” In addition, according to Gourmet Dining, it had not acquired the exclusive right to occupy the property, did not obtain the right to use the name “Ursino,” and had a duty under the contract to operate the restaurant to the satisfaction of the Kean Foundation.

To analyze the situation, the court consulted Van Horn v. Harmony Sand & Gravel, Inc., 442 N.J. Super. 333 (App. Div. 2015), for its guidance that the use of the term “lease” is not determinative of whether a contract is a lease or not. It may be a lease or it may be a “license,” which the Van Horn court described as “an agreement that only gives permission to use the land at the owner's discretion.” But if the agreement was a lease and not a license, then, in accordance with section 54:4-2-3, the leasehold interest could lose the tax-exempt status enjoyed by the lessor. To come to a conclusion on this point, the court sought the answers to two questions: 1) Did the MSA have the requisite features of a lease and, if so; 2) did the contract give Gourmet Dining the rights associated with a lease?

To have all the earmarks of a lease, the agreement between the Kean Foundation and Gourmet Dining would have to: 1) be a contract; 2) for a defined property; 3) to be in effect for a defined period; and 4) require the party taking possession of the premises to pay a fixed amount. All of these factors applied to the MSA contract, as Gourmet Dining had the right to operate, manage and control the facility, for 10 years, and for an agreed-upon payment to be made to the Kean Foundation.

Having determined that the basic elements of a lease existed under the MSA, the next question was whether the MSA afforded Gourmet Dining rights akin to those of a lessee. For help on this, the court turned again to the New Jersey Supreme Court's Thiokol Chemical case. There, the United States had contracted with a private company, allowing it to use U.S. land and the improvements upon it to do work for the United States. The Thiokol court determined that the agreement between the United States and the company was not a lease because the United States retained the right to inspect the company's work, controlled the work by keeping a staff of 10 U.S. employees on the property for that purpose, and had the right to terminate the private company's services on written notice at any time. These things meant that the private company lacked the rights of a lessee — it had only limited control over the property in question, and its rights were immediately extinguishable by the United States, even absent cause. Such was not the case with the Kean Foundation/Gourmet Dining agreement, which afforded Gourmet Dining concrete rights that lessees enjoy.

Further, the court noted that while the MSA required Gourmet Dining to operate only a restaurant and no other business, did not permit it to control the name of the business, and compelled it to meet certain standards set by the University's representatives — all tending to indicate a license rather than a lease — many leases require a lessee to run a specific type of business, and only that one type, and require lessees to meet specific minimum standards, such as preserving the property in good condition and refraining from interfering with other lessees on the premises. So these things were not dispositive. On the contrary: “Under the MSA,” the court stated, “Gourmet Dining retains a possessory right in the subject property and control over Ursino's operations, employees, liquor license, income and expenses. The MSA does not financially restrain Gourmet Dining in any manner. The MSA grants Gourmet Dining 'the exclusive right to operate, manage and control the Facility …' and names Gourmet Dining as 'exclusive manager of the Facility,' responsible for 'all reasonable, necessary and advisable management and operational services … and in compliance with all applicable municipal, county, state and federal laws, statutes, ordinances, rules and regulations.'” The court found it even more significant that the MSA gave the Kean Foundation no right to unilaterally terminate the agreement without cause. Rather, the court observed: “Under the MSA, Gourmet Dining enjoys the right to freely operate Ursino on its own terms, and hence can be said to enjoy the exclusive use, enjoyment, and possession of the subject property.”

All these things led the court to conclude that, for the purposes of deciding the motion for summary judgment, Union Township had established that the MSA was “functionally a lease,” despite the Kean Foundation's continuing rights to do certain things that most leases may not allow. Stated the court: “The MSA may not be an optimal agreement from Gourmet Dining's perspective, but a lease with less-than-ideal terms does not cease to be a lease.”

Therefore, the Gourmet Dining leasehold interest was amenable to being taxed, unless it could be shown, in accordance with other statutes, that Gourmet Dining's Ursino restaurant was entitled to immunity from taxes because it stood in the shoes of Kean University by serving the public interest Kean University was entrusted with serving.

Actual Use

New Jersey Statutes Annotated 54:4-3.6 explains that premises used by educational entities are to be tax-exempt, so long as they are actually being used for educational purposes. The statute states, in pertinent part:

The following property shall be exempt from taxation under this chapter … all buildings actually used for colleges, schools, academies, or seminaries, provided that if any portion of such buildings are leased to profit-making organizations or otherwise used for purposes which are not themselves exempt from taxation, said portion shall be subject to taxation and the remaining portion only shall be exempt.

Gourmet Dining and Kean claimed that the Ursino property was actually being used for college purposes. Their primary argument here was that because Kean was paid the management fee and a percentage of gross revenues, the restaurant's profit (or at least some of it) was going back to Kean University's “cause of education.”

The court was unconvinced, however, because although some profits went to Kean, most of the profits were still going to Gourmet Dining. As explained in City of Trenton v. State, Div. of Tax Appeals, 65 N.J. Super. 1 (App. Div. 1960), the question to be asked in situations like this is, “Who gets the money?” The City of Trenton court said that if money is generated from profit-making operations on a normally tax-exempt property, courts should look to see if it can be traced to “someone's personal pocket” and to whether that profit is the primary reason for the operation. If so, then the entity profiting from the use of that otherwise tax-exempt property is not entitled to tax immunity.

Here, the court concluded that “all profit belongs to Gourmet Dining.” Thus, Gourmet Dining was not entitled to exemption from tax based on an actual use of the property for educational purposes.

Serving the 'Public Purpose' of Kean University

New Jersey Statutes Annotated 54:4-3.3 states, in pertinent part to the public purpose/tax exemption issue: “[T]he property of the State of New Jersey; and the property of the respective counties and municipalities, and their agencies and authorities, school districts, and other taxing districts used for public purposes … shall be exempt from taxation under this chapter.”

The court found because Kean University was established as a part of the New Jersey Association of State Colleges and Universities in accordance with N.J.S.A. 18A:64-45, Kean University was a public entity, and the NJCSTM Building was a governmental property, such that N.J.S.A. 54:4-3.3 applied to them. “Additionally,” stated the court, “it is undisputed that Gourmet Dining is a for-profit corporation, and its operation and management of Ursino are conducted for-profit.” Therefore, the court was required to determine, in accordance with Township of Holmdel v. New Jersey Highway Auth., 190 N.J. 74, 918 A.2d 603 (2007), whether Gourmet Dining's “use, possession, and occupancy of the subject property as a restaurant fulfills a statutory purpose afforded to Kean.”

First, the court observed that New Jersey's Supreme Court held the case of Borough of Moonachie v. Port of New York Authority, 38 N.J. 414 (1962), that “property employed primarily for a public use does not lose immunity [from taxation] because [an] agency incidentally derives some private business income from it.” And just as a government entity can gain incidental income while serving its public purpose without losing its tax-exempt status, a lessee of the agency might also enjoy tax immunity under circumstances akin to those that would exempt the agency itself, so long as the lessee is operating the property in accordance with the agency's statutory purpose. See, Township of Holmdel, supra. However, Borough of Moonachie also explains that “a tax exemption based upon a statute specifying a particular public use is clearly lost when the use to which the property is put is foreign to the prescribed use and the revenue motive in adopting the use is the primary or exclusive one.” Therefore, if Gourmet Dining and Kean wanted to show the restaurant's operators were entitled to tax exemption under N.J.S.A. 54:4-3.3, they would have to show that Gourmet Dining was carrying on the public purpose of Kean University.

Gourmet Dining and Kean argued that the restaurant operator was promoting the public purpose of Kean University because: 1) the restaurant is a public dining establishment that may be used by Kean students and the Kean community; 2) a portion of Ursino's gross revenues are paid to the Kean Foundation, which in turn, provides scholarships to Kean students; 3) Ursino raises the public profile of Kean University; 4) the restaurant provides employment opportunities for Kean University students; and 5) Ursino is integrated into Kean's mission of environmental stewardship. On all of these arguments the court was unimpressed.

The fact that the university's students, instructors and administrators were entitled to eat in the restaurant, along with the rest of the public, did not show that the restaurant was an extension of Kean University's provision of a public good, the court concluded. Granted, the provision of dining facilities for the use of students and other university-affiliated persons is specifically designated by the State's legislature as a legitimate activity furthering the mission of public institutions of higher learning under N.J.S.A. 18A:72A-18. However, Ursino did not fit into the definition of a university dining facility. Ursino did not, for example, allow students, faculty or administrators to eat there on any university food plan. The university also did not designate Ursino as one of the university's student dining options in its literature, though it cited to six other such establishments, and Ursino offered no discount to students or faculty. Therefore, the court concluded that Gourmet Dining, by allowing students to eat in Ursino at market rates, could not claim to be providing any public service Kean University was charged with providing.

The provision of scholarship money did not move the court either, as it saw no good reason that a “for-profit entity should be entitled to a local property tax exemption simply because part of its gross revenue stream is remitted to a public entity and then allegedly allocated to further the public entity's purpose.”

Gourmet Dining and Kean then argued that Ursino was being “used for public purpose” because it “fulfills the University's plan to have a restaurant that raises the public profile of the University.” The court didn't really bother to explain why this point did not sway it in Gourmet Dining's direction, possibly because it considered any rise in the university's public profile attributable to the restaurant's existence to be minimal, or perhaps because the raising of the university's public profile was simply not a “public purpose” germane to the question of tax-exemption.

As to student employment at Ursino, the court noted that any such jobs were merely incidental — some employees were students, others were not, and none of the students were working at the restaurant because of work-study programs or the university's provision of financial aid to them. This was not enough to warrant an extension of the university's public-purpose-based tax exemption to the restaurant's operators. “If this court were to conclude, as Gourmet Dining suggests, that the employment of college students serves a public purpose,” the court opined, “then any for-profit business operated on, or in close proximity to, a college or university employing students would be entitled to seek a local property tax exemption. Affirmation of such proposition would eviscerate the current system of local property tax assessment and exemptions.”

Ursino's participation in Kean University's environmental stewardship initiative was also inadequate to convey tax-exemption to the restaurant. The court found that although the restaurant bought much of its produce from a farm operated by Kean University and returned to the farm compostable refuse, Gourmet Dining “proffered no evidence to show that the produce purchases from, and compost contributions to, Kean are not simply arms-length business transactions entered into for the convenience of Gourmet Dining, or as cost saving mechanisms for Gourmet Dining with regard to the positive image fostered by such transactions.” Besides this, nothing in the lease contract itself required Gourmet Dining to buy from the university's farm or to give back to it compostable materials.

Conclusion

The agreement between the Kean Foundation and Gourmet Dining may not have looked like a traditional property lease, but several things overrode the “management contract” language to convince the court that it was nevertheless a lease; particularly important were the amount of freedom the restaurant company retained to run the operation as it saw fit, and the guarantee that, absent breach, Gourmet Dining would remain in possession of the restaurant premises for the agreed-upon fixed term. The “actual use” argument also fell flat, and although New Jersey's case law shows the state interprets broadly the term “public purpose,” when it came to extension of the university's tax-exempt status to this lessee, the definition could not be stretched quite far enough to help Gourmet Dining.

The lessons to be taken from Gourmet Dining are that fashioning a contract in a way to make it appear that it is not a lease but something more like an employment contract are likely to fail when the classic indicia of a lease — like transfer of the right to possession of a premises, payment for same, and a guarantee of the transferee's continued possession for a set term — are present. And vague or minor contributions to a tax-exempt entity's mission will not counter the fact that a private lessee's purpose for using the leased property is its own profit.

Ultimately, when the arrangement is anything like Gourmet Dining's and Kean University's, any private party contracting to use what was previously a tax-exempt property for a profit-making operation should figure tax costs into its business decisions.

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Janice G. Inman is Editor-in-Chief of this newsletter.