August 23, 2013

Joint Ventures – Why now?

The nonprofit sector has seen a growth in all types of corporate restructurings, including joint ventures.  Why?

• New sources of revenue
• Places to cut costs
• Emphasis on social enterprise

Accordingly, we’ve seen organizations that might never have contemplated complex structures in the past looking for alternatives.

What is a Joint Venture?

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For today, we will use a narrow definition of a joint  venture – generally, an arrangement whereby a nonprofit organization and a for-profit organization jointly participate in an activity through a subsidiary entity.

• Not grantmaking or program-related investing
• Not contracting (although there are lessons to be learned from that area)
• Not debt

Two Types of Joint Venture

1. Whole Entity Joint Ventures

• The nonprofit entity places all of its operations into the joint venture; the nonprofit’s sole activity is to act as the participant in the joint venture, and to spend any distributions it may receive.
• Typically in the hospital area – thus, whole hospital joint ventures

2. Ancillary Joint Ventures

• The nonprofit places a discrete activity in the joint venture, but retains significant operational activities within its primary structure.

An Approach to Joint Ventures

• First, do you have an inurement issue that could cost the nonprofit its tax-exempt status? If so, stop!
• Second, do you have a charitable purpose for participating in the joint venture?
• Third, if yes, can you protect and enforce that charitable purpose to prevent private benefit?
• Fourth, if no (e.g., the purpose of the joint venture is purely to produce income), is it UBTI?
• Fifth, if it is UBTI, do you have so much UBTI that it endangers the nonprofit’s exempt status?

Step One: Inurement

Step one is to look for private inurement issues under Section 501(c)(3)

“...no part of the net earnings of which inures to the benefit of any private shareholder or individual...”

Generally speaking, inurement is the use of the asset or earnings of a nonprofit to benefit an insider of an organization.

 - Inurement in Joint Ventures

Inurement requires an “insider” – someone with a “personal and private” interest in the organization.

• Anyone who is a director, officer, etc.
• Anyone with de facto control of policies and assets
• Hospitals – certain doctors

If insiders are participants in the joint venture on the for-profit side, or if insiders will benefit from the joint venture, inurement is an issue. Examples:

• Non-pro rata distributions; loan guarantees; leases; preferences on dissolution; compensation; use of charitable assets; low valuations

Step Two: Purpose

Step two requires the nonprofit organization to analyze its purpose for participating in the joint venture:

• Is the purpose of the venture primarily to engage in an activity that furthers the organization’s charitable purpose; or
• Is the purpose of the venture primarily for investment or to create an income stream to support other charitable programs?

Charitable purpose:

• Under the regulations, a nonprofit can engage in a trade or business.
• The production of income, even to support charitable activities, is not in and of itself charitable.
• Plumstead Theatre provides that an organization can further its charitable activities through participation in for-profit entities.
• If the purpose is not charitable, then skip to UBIT analysis.

Charitable Purpose?

The Operational Test:

• Section 501(c)(3) requires an organization to be “organized and operated exclusively” for one or more tax-exempt purposes.
• The operational test requires an organization to operate in a manner that is exclusively for tax-exempt purposes.
• “Exclusively” does not mean to the exclusion of everything else; “exclusively” means that the organization engages primarily in activities that accomplish tax-exempt purposes.
• An organization can engage in an insubstantial amount of some activities that are not directly charitable in nature, so long as those activities are not otherwise prohibited by the statute. Examples:
  • lobbying, investment activities, or an unrelated trade or business, so long as these activities are insubstantial.

Charitable Purpose?

Whole Entity Joint Ventures:

• If the activities in the joint venture are not charitable, then the nonprofit’s participation in the joint venture is not charitable and it fails the operational test.

Ancillary Joint Ventures:

• If the activities of the joint venture are charitable, it furthers the nonprofit’s exempt purpose

• If the activities of the joint venture are not charitable, are they insubstantial enough so as to not violate the operational test?

Step Three: Protect and Enforce

Assuming a charitable purpose, then can the nonprofit protect and enforce its charitable purpose?

• It is not sufficient to have a charitable purpose, and have no way to cause the joint venture to respect it.
• Failure to be able to enforce a charitable purpose can cause private benefit.
• Fair market value transactions are not enough!

Private Benefit

The private benefit doctrine is not directly in the language of Section 501(c)(3).

• It is a judicial corollary to the operational test.
• An organization must be operated exclusively for tax-exempt purposes.
• If a substantial purpose of the organization is to benefit certain private parties, it ceases to meet the organizational test.
• The organization may perform tax-exempt activities but the existence of a substantial private benefit taints it.

Private benefit is often confused with private inurement.

• In order to have inurement, the benefitted party must be an insider to the organization.

• Private benefit can apply even if the recipients of the benefits (here, the for-profit participant in the joint venture) have no influence over the nonprofit.
• In addition, there is a substantiality test to private benefit: a benefit that is incidental and tenuous may not endanger an organization’s exempt status.

Private Benefit in a Joint Venture

Most of the cases and rulings in the area of joint venture deal with the question of whether the organization’s participation in the joint venture fails the operational test:

• Can the organization enforce the charitable purpose so that it continues to meet the operational test? Or

• As a result of the inability to enforce, is there a private benefit to the for-profit participant?

Inherently, a “facts and circumstances” analysis, so the case law/rulings are important!

• Control issues can be contractual: see est of Hawaii

Revenue Ruling 98-15

Deals with whole hospital joint ventures

Gives a “good” example and a “bad” example

• In reality, most joint ventures are in between
• Neither of the examples contains prohibited inurement:
  • The joint venture is pro rata
  • Everything is for fair market value

Issues: what control does the nonprofit have?

• Statement of charitable purpose in the joint venture document and “fiduciary override”
• Board control (majority in good example, even split in bad example)
• Board approval of budgets, contracts, management services agreement in good example
• Management services agreement – good example: unrelated party, five-year contract, renewal requires agreement of both parties bad example; related to the for-profit, excessively long terms, difficult to cancel, easy for for-profit to renew.
• Overlap of key personnel
• See also: 2002 IRS CPE EO Text, Update on Health Care, at page 158

Redlands Surgical Center

Bad facts – whole entity joint venture to operate a surgery center.

• Equally divided board of managing directors
• Medical standards decisions rested with a medical advisory group, half of whom were selected by the managing directors.

• Management agreement with an affiliate of the for-profit partner
  • Required by partnership agreement
  • Term of 15 years with two 5-year extensions at the management company’s sole discretion.
  • Signed by the same person in dual capacities
  • Could be terminated only for breach with 90-days’ notice and 90-days’ cure or bankruptcy
  • Wide ranging powers delegated, including setting fees and most purchasing
  • Non-compete provisions: no other surgical center ventures within a 20-mile radius.
  • The managing directors determined what procedures would be performed at the surgery center; on a few occasions, the hospital’s representatives on the board had to block efforts to move certain types of surgeries to the surgical center.
  • Some of the hospital’s physicians, including board members, participated in the joint venture.
  • No statement of charitable purpose and imposed no requirement to operate in a charitable manner.
  • No free care, no emergency room, and most surgeries that would be covered by public programs
  • (Medicaid/Medicare) were not performed at the surgery center.

St. David’s

Slightly better facts:

• St. David’s did negotiate for a statement that the partnership would operate in accordance with the community benefit standard.

• It also obtained a provision stating that, if the management services agreement could adversely affect its tax-exempt status, St. David’s could unilaterally terminate the agreement.

However:

• St. David’s did not have majority control of the managing board of the joint venture – as with Redlands, it had the power only to block actions, not initiate them.
• The manner in which St. David’s could enforce the management services agreement - through termination or court action - was sufficiently onerous to prevent St. David’s from regularly questioning day-to-day decision making.
• Emphasis on relative bargaining power

The St. David’s case reinforces the issue that control of the joint venture, so that the NPC can cause the joint venture to engage in charitable activities, is the key to the analysis. Even if the joint venture actually operates in a charitable manner - which the Circuit Court stated that it did, in fact - it is not sufficient to support the continued tax exemption of the participating nonprofit.

Revenue Ruling 2004-51

A university that entered into an ancillary joint venture with a for-profit entity to produce educational videos for teachers.

• The board of managers was divided equally and the joint venture was pro rata and equal.
• The university had the exclusive right to approve the curriculum, the standards for successfully completing the training, and the instructors (i.e., educational issues).
• The for-profit had the right to determine the location of the video links to the training and the right to select certain non-instructor personnel.
• All other actions required mutual consent.

The Revenue Ruling specifically indicates that the University’s participation in the venture was insubstantial in terms of its overall activities.

The Service further ruled that the activities were related to the University’s exempt purpose and, therefore, not subject to UBIT.

Step 4: Is it UBTI?

An unrelated trade or business is defined as “any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its” tax-exempt purposes.

• An activity is substantially related if there is a causal relationship between the activity and the accomplishment of the NFP’s exempt purpose.
• The activities which generate the income must contribute importantly to the accomplishment of the organization’s exempt purposes to be substantially related.
• Note that in order to constitute an unrelated trade or business, an activity must first be a “trade or business” within the meaning of the tax code, and must also be regularly carried on.

A business activity can be broken down into component parts, such that a portion of the activity is related and a portion is not.

UBIT – By Entity

UBIT treatment of the distributions received from that entity will depend upon the form of entity.

Partnership (including a LLC taxed as a partnership):

• Look through the LLC to its underlying activities.
• Would the activity conducted by the partnership have been an unrelated trade or business if carried on directly by the NPC?
• Distributions retain their character as exempt or unrelated.
• Use if all or most of the joint venture’s activity will be related, and therefore, there is no adverse impact to having the character of the income attributed up to the nonprofit.

C corporation

• No look through to determine whether or not the activities are unrelated.
• Rather, the C corporation will be taxed at the entity level.
• Dividends from the C corporation are usually exempt from UBIT by statute.
• Use of a C corporation is helpful when there are significant trade or business activities at the joint venture level, and the NPC wishes to insulate itself from those activities.
• The downside of the use of a C corporation is that there is an entity level tax that does not distinguish between exempt and unrelated activities; therefore, to the extent that there are related activities, they will be subject to taxation.

S corporation

Step 5: Is it too much UBTI?

By statute, any distributions from the S corporation are deemed unrelated.

• Remember the operational test!
• Must be operated primarily for a tax-exempt purpose
• Non-tax-exempt activities are allowable if insubstantial
• This includes UBTI-producing activities
• What is insubstantial?
  • Is the time and attention of the organization diverted from its charitable purpose?
  • Not only income, but expense, staff resources, etc.
  • Informally, IRS on review of Form 1023 will allow 5%.

Author: Elaine Waterhouse Wilson

• Associate professor, West Virginia University College of Law, teaching federal income taxation, taxation of business entities, estate and gift taxation, and nonprofit organizations

• Previously a partner in private practice in the Tax-Exempt Organizations Group of the Chicago office of Quarles & Brady LLP (2007 to 2011); an associate and then partner in the Estate Planning Group of the Indianapolis office of Barnes & Thornburg LLP (1996 to 2007); and an associate in the Individual Client Practice of Sullivan & Cromwell in New York City (1993 to 1996)
• Named Nonprofit Lawyer of the Year for Chicago for 2012 by the Leading Lawyers Network • Vice chair, Charitable Group of the American Bar Association’s Section on Real Property, Trusts and Estates
• Listed in The Best Lawyers in America, 2007 to present, nonprofit/charities law
• Named to “40 Illinois Attorneys Under 40 To Watch” Law Bulletin Publishing Company, Chicago Lawyer magazine and The Chicago Daily Law Bulletin, 2009
• Received the 2006 Pro Bono Publico Award, Indiana Bar Foundation
• J.D. degree, magna cum laude, Boston University School of Law; B.A. degree, magna cum laude, Boston University College of Liberal Arts

For more information or training on Non-Profit and For Profit join ventures, visit www.lorman.com for all of your continuing education and training needs.