At the risk of stating the obvious: Receiving the imprimatur of the IRS does not protect your tax-exempt status from the scrutiny of other government agencies.

In 2008, a tax assessor in Morristown, New Jersey denied the property tax exemption for portions of the non-profit Morristown Memorial Hospital. The hospital’s parent company, Atlantic Health System Hospital Corp., sued the city. At the end of last month, a New Jersey tax court judge ruled against Atlantic Health System, finding that the hospital operated in a for-profit manner and therefore could not be exempt from local property tax. The ruling doesn’t affect the hospital’s federal tax-exempt status, but it does open it up to liability for property taxes estimated at $2.5 million per year.

Judge Vito Bianco considered several factors in reaching his decision, among them the hospital’s complicated corporate structure, which included numerous for-profit entities. The opinion also cited the hospital’s relationships with for-profit physician practices, including the payment of recruitment incentives and loans to physicians. Compensation was another key factor: the judge found that the hospital’s executive compensation was unreasonably high, and its compensation to employed physicians was designed to incentivize them to generate profits for the hospital. Similarly, some third party service contracts contained compensation that, in the judge’s view, was profit sharing disguised as cost savings.

Judge Bianco was apparently not pleased with what he saw in Morristown Memorial, noting that, “If it is true that all non-profit hospitals operate like the Hospital in this case, as was the testimony here, then for purposes of the property tax exemption, modern non-profit hospitals are essentially legal fictions.” Ultimately, he concluded that only the hospital’s auditorium, fitness center, and visitors’ parking garage were actually operated in a non-profit manner and could therefore be exempt from property tax.

Morristown Memorial is not the first non-profit hospital to face this kind of tax challenge, nor is it likely to be the last. There have been previous cases involving the University of Pittsburgh Medical Center and Provena Covenant Medical Center in Illinois, among others. Provena was saved by its state legislature, who subsequently passed a law to allow hospitals to keep their state tax exemptions if they provide free or discounted care equal to or greater than their property tax liability.

Last week, Morristown and Atlantic Health System announced that they were engaging in settlement discussions to resolve the matter. Remaining unsettled, however, is the future tax treatment of non-profit hospitals, as other cities and states may begin to reexamine the taxes paid by their area non-profit entities. Unfortunately, the Morristown ruling does not provide any clear guidance to other non-profit hospitals, perhaps other than a reminder that how you operate matters.