Volume 18, Number 2
March 2001

Business and Commercial Law

New Horizon for Nonprofits

How to Structure Joint Ventures with For-Profits

By Michael I. Sanders

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. 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.

A nonprofit’s 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 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 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). The difficult issues involving a nonprofit’s 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 nonprofit’s resources, personnel, and assets is crucial because failure to satisfy the IRS’s criteria can result in the loss of tax-exempt status.

On March 4, 1998, the IRS released a long-awaited revenue ruling on whole-hospital joint ventures. Revenue Ruling 98-15 incorporates the following two-part test, with a focus on whether nonprofits "control" the ventures in which they participate: the activities of the venture must further charitable purposes; and the structure of the venture must insulate the nonprofit from potential conflicts between its charitable purposes and its joint venture obligations, and minimize the likelihood that the arrangement will generate private benefit. The first hurdle is to establish a charitable purpose. Then, the IRS scrutinizes a variety of factors that determine whether the nonprofit has sufficient control over the venture.

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’s 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. 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 venture’s 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 venture’s 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 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 a term so long that control is effectively vested in the management company.

Moreover, nonprofits must be 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 (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. The use of a veto as a viable device for preserving nonprofit control in the 50/50 joint venture will be suspect in the IRS’s view, unless coupled with safeguards that vest control with the nonprofit.

Revenue Ruling 98-15 addresses the tax treatment of nonprofit hospitals involved in whole-hospital joint ventures with for-profit entities. The IRS has indicated through private letter rulings and informal comments that the reasoning of Rev. Rul 98-15 will also apply to "ancillary" joint ventures in which the nonprofit invests a smaller part of its assets.

In some circumstances, it may be advantageous to create a for-profit subsidiary to participate in the joint venture. In a private-letter ruling 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. 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’s approval is maintaining the formal independence of the subsidiary. In the AARP ruling, the IRS lists 25 requirements for establishing independence. The key elements of separation in the AARP ruling include:

• A majority of the subsidiary’s board of directors or the executive committee cannot be current officers or directors of the exempt parent, but the parent’s executive director (or CEO) can serve on the subsidiary’s board and its executive committee.

• The CEO of the exempt parent cannot also serve as the CEO of the subsidiary, and most of the subsidiary’s employees must not be shared with the parent. However, the exempt parent’s board, through its CEO, can have the authority to remove any directors of the subsidiary, assuming it has authority to elect or appoint the subsidiary’s directors.

• The exempt parent may provide space and administrative services to the subsidiary, paid for by the subsidiary at the parent’s cost.

• The parent may furnish all of the subsidiary’s 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.

Nonprofits involved in joint ventures must carefully study recently published rules on intermediate sanctions (I.R.C. § 4958 and Treasury Regulations § 53.49581T et seq.). 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 nonprofit’s assets. Intermediate sanctions were enacted to provide the IRS with an alternative to revocation of an organization’s 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 by the organization exceeds the fair market value of the consideration provided by the disqualified person. 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 organization’s exemption.

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.

Michael I. Sanders is a partner with Powell, Goldstein, Frazer & Murphy, LLP, in Washington, D.C.

- This article is an abridged and edited version of one that originally appeared on page 53 of Business Law Today, July/August 2000 (9:6).

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