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.

Prior IRS Rulings and Related Case Law

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

The Facts

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 Analysis

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.

Footnotes

1. 2002-1 USTC ¶50,452 (W.D. Tex. 2002), rev’d and remanded, 349 F.3d. 232 (5th Cir. 2003), St. David’s Health Care System v. United States of America, Civil Action No. A-01-CA-46 JN (See 2004 TNT 46-4).

2. Section 512-1(d)(2)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Sign Up
Gain free access to lawyers expertise from more than 250 countries.
 
Email Address
Company Name
Password
Confirm Password
Country
Position
Industry
Mondaq Newsalert
Select Topics
Select Regions
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions