United States: IRS Revenue Ruling Approves Tax-Exempt Organization Participation In Ancillary Joint Ventures

On May 6, 2004, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) issued Revenue Ruling 2004-51 (the Ruling), which approves exempt organization participation in "ancillary" joint ventures under certain circumstances. A revenue ruling is a precedential document, that is, one which all taxpayers can rely in dealings with the IRS. The ruling involves the formation of a limited liability company (LLC) by a university tax-exempt under Section 501(c)(3) and a for-profit company for the purpose of offering off-campus, summer training programs for secondary school teachers using interactive video technology. The Ruling is an important development and provides needed guidance for all exempt organizations in the joint venture areaone that has been in flux for at least the past six years.

The Ruling follows Revenue Ruling 98-15, which addressed the exemption implications of an exempt organization’s participation in "whole hospital joint ventures," which is a joint venture between an exempt organization and a for-profit entity to which the exempt participant transfers all of its hospital facility assets and operations. Revenue Ruling 2004-51 addresses the same question in the context of an ancillary joint venturea joint venture between and exempt organization and a for-profit entity in which the joint venture’s activities represent an insubstantial portion of the total activities of the exempt participant.

The key focus of Revenue Ruling 2004-51 is on the extent to which the exempt organization must control the activities of the LLC in order to avoid adverse tax-exemption implications. In Revenue Ruling 2004-51, the IRS concludes that the exempt university may participate in the ancillary joint venture under the facts and circumstances set forth in the ruling, even if it does not have majority voting control over all aspects of the LLC’s decision-making, without either endangering its tax-exempt status or having its allocable share of income from the LLC treated as unrelated business income (UBI). Revenue Ruling 98-15 did not address the UBI tax implications of the whole hospital joint venture. The key factor supporting this conclusion is the degree of exclusive control the exempt university exercises over certain aspects of the LLC’s activities that affect whether the LLC operates in a manner consistent with the exempt organization’s charitable purposes. Specifically, the university retains the exclusive right to approve the curriculum, training materials and instructors for, and to determine the standards for the successful completion of, the seminars offered by the LLC.

Other facts and circumstances the IRS cites in support of the favorable ruling focus primarily on the provisions of the LLC governing documents dealing with the purposes and activities of the LLC and its affect on the exempt status of the university; the equal voice of the members in making non-curriculum or business decisions with respect to the LLC; the allocation of profits and losses of the venture in proportion to each party’s capital contribution; and the arm’s-length nature and market comparability of the contractual relationships between the LLC and either of the venturers or third parties.

Until 1998, the leading authority on exempt organization participation in partnerships with for-profit entities was a 1982 decision of the U.S. Court of Appeals for the Ninth Circuit in Plumstead Theatre Society v. Commissioner. (T.C. 1324 (1980), aff’d per curiam, 675 F.2d 244 (9th Cir. 1982). In that case, the court addressed the Section 501(c)(3) exemption implications of an exempt theatre organization’s participation as the sole general partner in a limited partnership with a for-profit corporation and individuals. The purpose of the partnership was to raise funds to produce a play. From Plumstead, there emerged a two-part test for evaluating joint ventures between exempt and non-exempt participants: whether participation by the exempt organization furthers the organization’s exempt purposes; and whether the joint venture arrangement permits the exempt organization to act exclusively in furtherance of exempt purposes and not other than incidentally for the benefit of the for-profit partners. The question of control arose only as to whether the terms of the joint venture relationship in some way gave the for-profit joint venture participant control directly or indirectly over the exempt theatre organization’s operations, not as to the extent of control the exempt theatre organization had over the activities of the joint venture. Since 1982, the IRS has consistently applied this two-part test to evaluate the exemption implications of joint ventures involving 501(c)(3) tax-exempt organizations. Examples of non-precedential publications in which the IRS has applied this test include GCM 39862 (November 22, 1991) (net income stream joint ventures) and GCM 39732 (November 4, 1987); GCM 39546 (August 14, 1986); and GCM 39005 (June 28, 1983).

In Revenue Ruling 1998-15, however, the IRS focused for the first time on the extent to which the exempt organization controlled the joint venture as a key consideration in assessing whether a whole hospital joint venture between a for-profit hospital chain and a Section 501(c)(3) hospital entity adversely affected the hospital entity’s exempt status. Owning the joint venture interest and making grants with its joint venture distributions were the only activities of the exempt organization. The ruling addressed two fact situations. In one fact situation, the exempt organization controlled the joint venture through majority board representation. This exempt organization retained its tax exemption. In the second fact situation, the exempt organization and the for-profit partner had an equal number of representatives on the joint venture board, the for-profit partner had a 50-year contract to manage the joint venture, and the joint venture agreement did not specify that it would operate the hospital for charitable purposes. This joint venture arrangement was determined to be inconsistent with continued 501(c)(3) tax-exemption for the organization that had contributed all of its hospital assets to the venture. Revenue Ruling 98-15 addressed only the situation in which the activities of the joint venture attributed to it under partnership tax principles served as the only basis for its continued exemption. However, it did not address the far more common situation in which an exempt organization wishes to participate in a joint venture ancillary to the substantial exempt activities the entity otherwise conducts on its own. Moreover, the Ruling did not address the UBI tax treatment of the joint venture distributions received by the exempt organization that retained its overall exempt status because its finding on the exemption issue made it unnecessary to do so. Since the issuance of Revenue Ruling 98-15, two court cases have also focused on the control consideration in joint ventures between exempt health care organizations and for-profit entities Redlands Surgical Services v. Commissioner (113 T.C. 47 (1999), aff’d per curiam, 242 F.3d 904 (9th Cir. 2001) and St. David’s Health Care System, Inc. v. United States¹ . Redlands analyzed the control factor in the context of an exempt organization whose sole activity was participation in a joint venture with a for-profit entity for the purpose of owning and operating an ambulatory surgery center. Like Revenue Ruling 98-15, St. David’s addressed the control factor in the context of a classic whole hospital joint venture. In both cases, the appeals courts concluded that ceding control to taxable venturers constituted a substantial private benefit inconsistent with continued exempt status for the exempt venturer. On remand from the U.S. Court of Appeals for the Fifth Circuit, however, the jury for the Texas District Court in St. David’s ultimately decided that the exempt organization had sufficient control over the venture to support continued exempt status in the venture and such majority control was unnecessary.

Revenue Ruling 2004-51 addresses ancillary activity joint ventures, not whole entity joint ventures. The Ruling describes the following fact situation. A tax-exempt university described in Section 501(c)(3) offers on-campus, summer seminars for teachers as part of its more extensive educational programs. The for-profit company specializes in conducting interactive video training programs. The university and the company form the limited liability company for the purpose of offering summer training seminars for secondary school teachers at off-campus locations using interactive video technology (Distance Learning Program LLC). This expands the reach of the university’s teacher training seminars.

The LLC’s governing documents provide that the purpose of the joint venture is limited to carrying on the distance learning program. The governing documents provide that returns of capital, allocations and distributions will be proportional to the joint venturers’ 50/50 ownership interests. The governing documents expressly preclude the LLC from engaging in any activities that would jeopardize the university’s tax exempt status. The governing documents also require all of the LLC’s contracts and transactions, whether with the venturers or other parties, must be at arm’s length and at fair market value prices. The Ruling does not prescribe the terms that such agreements may have or the LLC apparently will not be managed pursuant to a management contract.

While the Ruling indicates that the university contributed a portion of its assets to the LLC, the Ruling does not describe what the contributed assets were or how they were valued. The LLC’s governing documents further provide that the LLC will be managed by a governing board made up of three directors chosen by the university and three directors chosen by the for-profit company. The university has the exclusive right to approve the LLC’s curriculum, training materials and instructors and to determine the standards for successful completion of the seminars. The for-profit company has the exclusive right to select video link locations and approve other personnel necessary for operating the seminars. All other decisions require the approval of both parties. The Ruling does not indicate whether either party agrees not to compete with the LLC’s activities or whether other restrictions are placed on what outside activities the joint venturers may conduct.

The Ruling states that the university’s participation in the LLC will be an insubstantial part of the university’s activities, but does not indicate how insubstantiality is measured for this purpose.

The Ruling explains that, when an exempt organization participates in a joint venture that is treated as a partnership for tax purposes, the activities of the joint venture are attributed to the exempt organization for purposes of determining both: whether the exempt organization is operated exclusively for exempt purposes and, therefore, remains tax-exempt; and whether the joint venture’s activities cause the exempt organization to be viewed as conducting an unrelated trade or business causing the exempt organization’s distributive share of joint venture income to be UBI subject to tax.

The Ruling concludes that the university’s participation in the 50/50 joint venture will not adversely affect the university’s continued tax-exempt status. This is because the activities the university is conducting through the joint venture are not a substantial part of the university’s activities.

The Ruling also concludes that the activities the university is conducting through the joint venture are not an unrelated trade or business and do not create UBI for the university. The key factor supporting this conclusion is the exclusive control the exempt university exercises over the important, educational aspects of the joint venture’s activities that affect whether the joint venture operates in a manner consistent with the exempt organization’s exempt purposes. Specifically, the university retains the exclusive right to approve the curriculum, training materials and instructors for, and to determine the standards for successful completion of, the seminars the joint venture was formed to conduct. The Ruling does not explain why this control element is determinative; however, the university’s control over these aspects of the joint venture program presumably permits the university to ensure that the training programs are conducted in a manner consistent with its educational purposes.

The IRS cites several other factors in support of its favorable conclusion on the UBI issue including the training programs covered by the LLC cover the same content as the university’s on-campus seminars; the for-profit member retains exclusive control over only the selection of the locations for and approval of the personnel necessary to conduct the training programs; and the governing documents of the LLC:

• limit the purposes of the LLC to conducting the distance learning programs;

• prohibit the LLC from engaging in any activities that would jeopardize the university’s Section 501(c)(3) status;

• provide for a board of the LLC consisting of an equal number of representatives of both the members;

• provide that all other decisions shall be made by mutual consent of each of class of representatives on the LLC board; and

• require that all returns of capital, allocations and distributions shall be made in proportion to the members’ respective ownership interests; and

• all terms of the contracts and transactions entered into by the LLC, either with its members or with third parties, must be at arm’s length and priced at fair market value for comparable goods and services.

The Ruling’s UBI analysis does not address certain factors relating to governance and operation of the joint venture that were considered important in addressing the overall exemption issue in previous IRS guidance and case law (e.g., covenants not to compete and management agreement provisions such as percentage compensation arrangements, termination rights). In addition, the ruling is limited to the specific, favorable facts and circumstances described, and, unlike many other revenue rulings, it does not provide a contrasting "bad" fact pattern to illustrate how varying facts and circumstances will affect the IRS assessment of the exempt status and UBI considerations. The Ruling states that the university’s participation in the joint venture will be an insubstantial part of the university’s activities, but does not indicate how insubstantiality is measured for this purpose. Nor does the Ruling provide insights into what will constitute sufficient control over joint venture activities in various types of joint venture transactions, such as those in the health industry, in which both participants will likely have expertise and experience in developing and conducting health care activities of the type undertaken by the joint venture and, therefore, a corresponding interest in controlling the development and operation of the joint venture activities.

Nonetheless, the Ruling provides important precedential guidance in several respects. First, it describes the type of control the exempt participant must exercise over the activities of a joint venture to establish the relatedness of the joint venture’s activities to its tax-exempt purpose. Second, it applies the causal relationship test of the UBI regulations to determine relatedness,² which is a less stringent test than the Section 501(c)(3) primary exempt purpose test for qualifying for exempt status.Applying this less stringent test will lessen the risk that an exempt organization will incur UBI tax liability on its distributive share of joint venture income. Third, it confirms that an exempt organization may participate in an ancillary services joint venture that conducts a related trade or business without either jeopardizing its exempt status or incurring UBI tax liability.

The Ruling is relevant only when an exempt organization participates in a joint venture that is a pass-through entity for tax purposes, such as a partnership or limited liability company; that is, it is not relevant to the ownership of a minority or majority of a corporation’s stock.

Any exempt organization now participating in a joint venture with for-profit entities or individuals should undertake a review of the joint venture to assess whether the nature and extent of the exempt organization’s control over the activities of the joint venture is sufficient to support a the conclusion that the activity of the joint venture is related to its exempt purposes. If the control is insufficient, the exempt organization should consider whether a restructuring to establish sufficient control is feasible and, if not, whether the activity of the venture is substantial relative to the overall exempt activities of the exempt organization. If substantial, the exempt organization may need to consider withdrawal from or termination of the venture. Even if only insubstantial, the exempt organization should reevaluate its UBI reporting position with respect to distributions of joint venture income.

Exempt health care organizations participating in joint ventures with physicians or other for-profit partners must also consider legal issues, other than tax exemption, that may restrict or prevent joint venture participation, such as federal physician self-referral prohibitions, the Medicare and Medicaid anti-kickback laws and the antitrust laws, to name a few.