ABA Section of Business Law
ABA Section of Business Law
Business Law Today
New horizon for nonprofits How to structure joint ventures with for-profits
By MICHAEL I. SANDERS
Its a joint venture with a twist. The combination is a good cause with revenue potential.
Tax-exempt organizations are continually entering into business arenas traditionally held captive by taxable commercial entities. Exempt organizations are becoming more entrepreneurial, as government funding for the nonprofit sector has decreased and "competition" among nonprofits for contributions from the general public has increased.
In fact, during the 20-year period from 1975-1995, the revenue of all nonprofits increased 380 percent nearly quadrupled while the amount of contributions did not even double. "A 20-year Review of the Nonprofit Sector, 1975-1995," No. 2, Internal Revenue Service Statistics of Income Bulletin (Fall 1998).
Today, exempt organizations can be found operating diverse business enterprises such as organizing travel tours; publishing magazines; selling medical equipment, art work, T-shirts, jewelry, life and health insurance; developing retirement communities; conducting business and estate-planning seminars; marketing video productions; operating pharmacies and managing investment firms. Even the Internet has become a source of revenue as nonprofits receive income for advertising in their online publications and are selling merchandise via the Internet, in a manner similar to catalog sales.
The trend toward commercialism is underscored by two front-page New York Times articles involving nonprofits appearing in a three-week period. The first, on Sept. 25, 1999, discussed how the College Board, the tax-exempt organization that administers the SAT, was creating a for-profit subsidiary to establish a Web site. The site was created to allow the College Board, a 100-year old organization, to compete with for-profit Internet entities that offer services to college-bound students. The second article appeared on Oct. 8, 1999 and discussed how universities are fueling high-tech booms across the United States. In fact, there are now so many university-linked research parks that they have their own association the Association of University-Related Research Parks.
Joint ventures between nonprofit and for-profit organizations are one method by which nonprofits can expand their activities. Joint ventures give nonprofits the opportunity to raise capital outside of individual and corporate giving while offering third parties a stake in the enterprise; neither can be done directly with nonprofits since they are not "owned" and only distribute earnings for their respective charitable purposes.
In addition, a for-profit partner may bring its expertise to a venture and thereby enable a nonprofit to continue operations with enhanced capability and operating revenues. The case of the College Board illustrates these points it needed to raise $10 million for its new Internet activities and wanted to offer stock options to entice employees with Internet expertise. If the College Board had not formed a venture, it would not have been able to raise the funds with a promise of investment returns nor offer employee stock options.
A nonprofits participation in a joint venture with one or more for-profit entities can be structured in different ways. As long as certain strict organizational and operational requirements are met, a nonprofit may serve as the general partner of a partnership or, as is increasingly the trend, as a managing member of a limited liability company. Alternatively, a nonprofit may participate through a subsidiary or affiliated organization. Generally, a nonprofit may invest as a limited partner (or a nonmanaging, nonparticipatory member in an LLC) in any prudent investment although as a passive investor, it may be subject to tax on income generated by any activity unrelated to its charitable purposes (unrelated business income tax, or, UBIT).
Where a nonprofit devotes an insubstantial portion of its assets to a venture that does not meet the IRS guidelines for joint ventures as discussed below, the IRS will likely deem the income from the venture as "unrelated" and therefore subject it to income tax as UBIT, but its tax-exemption will not be jeopardized.
The difficult issues involving a nonprofits participation in a joint venture arise when the nonprofit plays an active management role in a joint venture or devotes a substantial portion of its assets to the venture.Compliance with IRS guidelines when structuring a joint venture that involves a substantial portion of a nonprofits resources, personnel and assets is crucial because failure to satisfy the IRS criteria can result in the loss of tax-exempt status.
Prior to 1982, a nonprofit automatically ceased to qualify as tax-exempt under IRC §501(c)(3) when it served as a general partner in a partnership that included private investors as limited partners, or otherwise shared net profits. See, G.C.M. 36,293 (May 30, 1975). The IRS reasoning was that the obligations of a nonprofit general partner to its for-profit limited partners were incompatible with operating "exclusively" for charitable purposes.
The IRS "per se" opposition to nonprofit involvement in joint ventures with for-profit investors was abandoned in 1982, with the issuance of the Plumstead Theatre Society decision. Plumstead Theatre Society v. Commissioner , 675 F.2d 244 (9th Cir. 1982) affg 74 T.C. 1324 (1980). In Plumstead, a theater company, organized to foster the performing arts, entered into a limited partnership with three for-profit investors to raise revenue needed to produce a stage play. The IRS denied tax-exempt status to Plumstead, on the grounds that it was not operated exclusively for charitable purposes.
Based on the safeguards contained in the limited partnership agreement, which served to insulate Plumstead from potential conflicts with its exempt purposes, the Ninth Circuit Court of Appeals disagreed, holding that Plumstead was operated exclusively for charitable (and educational) purposes, and therefore was entitled to exemption.
After Plumstead, the IRS used a two-prong "close scrutiny" test to determine the permissibility of joint-venture arrangements between nonprofit and for-profit entities. The two-prong test required:
that the activities of the venture further charitable purposes; and
that the structure of the venture insulates the nonprofit from potential conflicts between its charitable purposes and its joint venture obligations, and minimizes the likelihood that the arrange-ment will generate private benefit.
On March 4, 1998, the IRS released a long-awaited revenue ruling on whole-hospital joint ventures. Revenue Ruling 98-15, 1998-12 I.R.B.6. (In whole-hospital joint ventures, the nonprofit contributes all of its assets to the venture.) Revenue Ruling 98-15 incorporates the two-part test with a focus on whether nonprofits "control" the ventures in which they participate. That is, the first hurdle, establishing a charitable purpose, must be satisfied. Then, the IRS goes on to scrutinize a variety of factors that determine whether the nonprofit has sufficient control over the venture. The reasoning is that if the nonprofit lacks fundamental control, it cant protect its assets and cant cause the venture to fulfill its exempt purposes.
The ruling illustrates the type of facts and circumstances that the IRS considers significant in determining whether the requisite amount of control exists by presenting two situations, one "good" and one "bad." The first example in the ruling involved a number of facts and circumstances, all of which were favorable, while the second example involved facts and circumstances, all of which were unfavorable.
Some of the unfavorable factors may not be comparable to those found in the real world. For example, the management contract in the second example allows the management company to continuously renew the contract into perpetuity, while in practice, such a provision may be rare. Although Revenue Ruling 98-15 concerns whole-hospital joint ventures and contained some fact patterns that may not exist in the "real world," it provides significant guidance for all joint ventures involving IRC §501(c)(3) organizations.
Inherent control by the exempt organization over the organizational structure of a venture is crucial. To satisfy this requirement, the organizational documents for such ventures should contain legally enforceable provisions that vest the nonprofit with control over the venture. The IRS firm position on this issue provides nonprofits with significant leverage when negotiating joint-venture structures with for-profit partners.
In addition to drafting operating agreements to vest power in the nonprofit, the venture must actually be operated in such a manner so that the nonprofit may exercise its control. As discussed below, the key elements relate to day-to-day activities and include the capacity of the nonprofit, through its voting power in the venture, to commit the ventures assets for charitable purposes; the term of any management contract executed by the venture and the ability of the venture to terminate the contract for cause; and composition of the ventures management team, that is, whether the representatives chosen by the for-profit partners were previously employed by the for-profit partners.
Management agreements must be carefully drafted to comply with Revenue Ruling 98-15. The IRS clearly views an independent management company (not affiliated with the for-profit partner) as a positive factor, with terms in the management agreement that allow the exempt nonprofit a "way out." In other words, an agreement that unilaterally permits a management company to renew the agreement is unacceptable, as is a contract with such a long term such as 10 years that control is effectively vested in the management company.
Moreover, nonprofits must be extremely careful about allowing employees or former employees of for-profit partners to serve in key positions in the venture. The IRS appears to be primarily concerned that such persons would limit or "package" information flowing to nonprofit partners so that such partners would, as a practical matter, be deprived of some of their control because of the limited flow of information.
In Revenue Ruling 98-15, it is also apparent that the IRS believes that the power to block an action, that is, veto power, is, in itself, insufficient to demonstrate and promote an exempt purpose. For example, the nonprofit may be able to block the appointment of a joint-venture CEO that it believes may be insensitive to charitable goals, but cannot compel the appointment of a CEO it affirmatively supports.
In commenting on Rev. Rul. 98-15, Marcus Owens, former director of the IRS Exempt Organization Division, observed that there is no bright line rule [precluding the nonprofit veto] but that the requisite control will be determined based on the overall facts and circumstances. See, "Owens discusses newly released joint venture revenue ruling," Tax Notes Today, March 9, 1998. Thus, use of a veto as a viable device for preserving nonprofit control in the 50/50 joint venture will be suspect in the IRS view, unless coupled with other safeguards that vest a high degree of control with the nonprofit.
The IRS use of the control test, with its variety of facts and circumstances, has been upheld in a recent case, Redlands Surgical Services , where the Tax Court upheld the denial of exempt status to a joint venture formed by for-profit and nonprofit entities. Tax Court Docket No. 11025-97(X).
In arriving at its decision that private, rather than charitable, interests were being served, the court examined various factors similar to the factors the IRS enunciated in Revenue Ruling 98-15. The court noted, most significantly, that there was a lack of any express or implied obligation of the for-profit parties to place charitable objectives ahead of for-profit objectives. Moreover, the relevant organizational documents did not include an overriding charitable purpose.
In sum, nonprofits participating in joint ventures with for-profit entities or private investors should carefully structure provisions in the agreements so that they are not deprived of control over the operations of the venture or limited in their ability to ensure that the venture will be operated for charitable purposes.
Revenue Ruling 98-15 addresses the tax treatment of nonprofit hospitals involved in whole-hospital joint ventures with for-profit entities. The impact of Revenue Ruling 98-15 on ancillary joint ventures in which less than substantially all of a nonprofits assets are transferred, is uncertain. However, at least one IRS representative has informally stated that the analysis in Rev. Rul. 98-15 is not limited to whole-hospital joint ventures. Comments by Catherine E. Livingston, associate tax counsel, U.S. Treasury Department, reported in the 96 Tax Notes Today 49-5 (1998).
In the authors view, the facts and circumstances analysis of Rev. Rule 98-15 can be readily applicable to an ancillary joint venture between a nonprofit and a for-profit, that is, does the nonprofit have control of the venture and does the venture have a primary charitable purpose? If the nature of an activity is such that direct participation by the nonprofit might jeopardize its exempt status, it may be possible to restructure the transaction by participating through a for-profit taxable subsidiary or affiliate. The taxable affiliate must be a bona fide entity separate from the nonprofit and must not be a mere arm of the exempt parent.
In a recent private-letter ruling widely known to have been issued to the American Association of Retired Persons (AARP), the IRS set forth a blueprint for the creation of a taxable subsidiary by a nonprofit. P.L.R. 19938041 (June 28,1999) By creating a subsidiary, the AARP was able to obtain tax-free treatment for royalties and other revenues from the licensing of intangible property rights.
The key to the IRS approval is maintaining the formal independence of the subsidiary. In the AARP ruling, the IRS lists 25 requirements for establishing independence, but most are typical of those outlined above for any corporation such as, separate boards of directors, separate board meetings and minutes. The key elements of separation in the AARP ruling were:
A majority of the subsidiarys board of directors or the executive committee cannot be current officers or directors of the exempt parent, but the parents executive director (or CEO) can serve on the subsidiarys board and its executive committee.
The CEO of the exempt parent cannot also serve as the CEO of the subsidiary and most of the subsidiarys employees must not be shared with the parent (some employees of the subsidiary may be shared with the parent). However, the exempt parents board, through its CEO, can have the authority to remove any directors of the subsidiary, assuming it has authority to elect or appoint the subsidiarys directors.
The exempt parent may provide space and administrative services to the subsidiary, paid for by the subsidiary at the parents cost.
The parent may furnish all of the subsidiarys capital as equity contributions so that the subsidiary need not pay interest on the contributions.
The exempt parent may furnish intellectual property (that is, mailing lists, know-how, etc.) to the subsidiary as a capital contribution.
As a practical matter, the nonprofit, through its CEO, may have absolute policy control of the subsidiary although the formalities of the subsidiarys day-to-day control, though its separate directors and officers will have to be maintained.
A new focus for nonprofits involved in joint ventures involves the recently enacted rules on intermediate sanctions (IRC § 4958). (Intermediate sanctions apply to §501(c)(3) and (4) organizations. Prop. Treas. Reg. § 53.4958-2.) Intermediate sanctions were enacted to provide the IRS with an alternative to revocation of an organizations exempt status in the event of substantial private benefit or private inurement.
An excess-benefit transaction is one in which the economic benefit provided to a disqualified person (a person having substantial influence over the affairs of the applicable exempt organization) by the organization (directly or indirectly) exceeds the fair market value of the consideration (that is, performance of services, etc.) provided by the disqualified person. Prop. Treas. Reg. §§ 53.4958-1, 53.4958-3, 53.4958-4.
If a nonprofit engages in an excess-benefit transaction, the person receiving excess benefit, as well as any organization manager who knowingly participates in the transaction, may be liable for a penalty tax, which is separate from possible revocation of the organizations exemption. Prop. Treas. Reg. § 53.4958-1. (The tax applicable to recipients of an excess benefit is equal to 25 percent of the excess benefit, while organization managers may be liable for 10 percent of the same.) Once an excess-benefit transaction is found to have occurred, an additional penalty will be imposed on the recipient of the excess benefit if the transaction is not corrected within a specified period. Prop. Treas. Reg. § 53.4958-1. This additional penalty tax is equal to 200 percent of the excess benefit.
Joint ventures create inherent susceptibility to intermediate sanctions for a number of reasons. First, compensation issues that may arise in a joint venture context are addressed in the proposed regulations, including incentive compensation and sharing of revenue.
Second, a for-profit entity that combines with a nonprofit in a joint venture may seek to have significant control over part (or all) of the nonprofits assets. This control may cause the for-profit partner, or an individual with such control, to be deemed to be a disqualified person with respect to the organization. Compensation arrangements and transfers of assets within the joint venture thus become subject to these new rules, which require all such transactions to be "reasonable."
The potential for nonprofits expanding their income bases and scope of activities is seemingly unlimited, particularly in the age of the Internet. Using joint ventures with for-profit partners as a vehicle to attain these goals is a viable option, provided it is done consistent with current guidelines.
Sanders is a partner with Powell, Goldstein, Frazer & Murphy, LLP, in Washington. He gratefully acknowledges the assistance of Gayle Forst in the preparation of this article.
The terms nonprofit and tax-exempt organization are used interchangeably and refer to organizations that are exempt from federal income tax under §501(c) of the Internal Revenue Code of 1986, as amended.
There are several categories of nonprofit organizations, the largest of which is §501(c)(3), which includes entities organized for religious, charitable, scientific and educational purposes.
A prerequisite for obtaining and maintaining exemption is that the charity be organized and operated exclusively for exempt purposes and that no part of its net earnings inure to the benefit of any individual.