Lawyer Article

Republished with permission of American Society of Association Executives

Beginning six years ago with the publication of Revenue Ruling 98-15, 1998-1 C.B. 718, the Internal Revenue Service, as well as the courts, have devoted considerable time and effort to analyzing the circumstances under which a section 501(c)(3) organization may become a member of a partnership or limited liability company (treated as a partnership for federal income tax purposes) with a for-profit partner without jeopardizing the organization's tax-exempt status. While this issue is not new, the issuance of Rev. Rul. 98-15 focused the attention of IRS field agents and ultimately the courts on this question. To the chagrin of perhaps many in the nonprofit community, the court decisions to date have generally agreed with the IRS's position in Rev. Rul. 98-15 that a tax-exempt organization must maintain effective control of the operations of a partnership with a for-profit entity to ensure that the partnership furthers the organization's charitable purposes, rather than the economic interests of the for-profit partner.

Recently, the IRS released Rev. Rul. 2004-51, 2004-22 I.R.B. (June 1, 2004), in which the IRS discussed 1) whether a section 501(c)(3) organization continued to qualify for tax-exempt status after entering into an "ancillary" partnership with a for-profit corporation and 2) whether the organization was subject to unrelated business income tax on its share of the income from the partnership. This article summarizes the salient events that have occurred during the past several years regarding partnerships with for-profit entities and attempts to discern what guiding principles, if any, can be derived from the relevant IRS pronouncements and court opinions.

Background

An organization is described in section 501(c)(3) of the Internal Revenue Code only if it is both organized and operated exclusively for charitable, scientific, or educational purposes, and no part of its net earnings inures to the benefit of any private shareholder or individual. The regulations under section 501(c)(3) provide that an organization will be regarded as operated exclusively for one or more exempt purposes only if it engages primarily in activities that accomplish one or more such purposes. An organization is not so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose. Even if an organization fulfills one or more exempt purposes, if its activities result, directly or indirectly, in conferring a more than incidental benefit on a private entity, then the organization will not be treated as being operated exclusively for tax-exempt purposes.

Revenue Ruling 98-15

In this ruling, often referred to as the "whole hospital joint venture" ruling, the IRS considered two situations in which a tax-exempt nonprofit corporation (the "organization") that owned and operated an acute care hospital formed a limited liability company with a for-profit corporation that also owned and operated a number of hospitals. The organization contributed all of its operating assets, including its hospital, to the LLC, while the for-profit corporation contributed some assets to the LLC as well. In return for their contributions, the two members received ownership interests in the LLC proportional and equal in value to their respective contributions.

The articles of organization and the operating agreement for the LLC in the first situation provided that it was to be managed by a governing board consisting of three individuals chosen by the organization and two individuals chosen by the for-profit. Those governing documents further provided that they could be amended only with the approval of both owners and that a majority of the board members had to approve a variety of certain "major decisions" relating to the LLC's operation of its hospital. Most importantly, the governing documents explicitly stated that the duty of the members of the governing board to operate the LLC in furtherance of charitable purposes by promoting health for a broad cross-section of the community overrode any duty they may have had to operate the LLC for the financial benefit of its owners. The LLC entered into a five-year management agreement with a company unrelated to the organization or the for-profit, the terms and conditions of which were reasonable and comparable to what other management firms would receive for similar services at similarly situated hospitals.

In the second situation described in the ruling, the facts were essentially the same as in the first except that the membership of the governing board of the LLC was split equally between the organization and the for-profit. In addition, the governing documents did not provide that in the event of a conflict between operation of the LLC's hospital in accordance with benefiting the surrounding community and any duty to maximize profits, the members of the governing board were required to satisfy the community benefits standard without regard to profitability. And lastly, the LLC in the second situation entered into a management agreement with a wholly owned subsidiary of the for-profit, which agreement had a five-year term, unlimited five-year renewal periods at the discretion of the subsidiary, and a termination clause that permitted cancellation of the agreement only for cause.

The ruling correctly posits that under the "aggregate" theory of partnership taxation, the activities of a partnership are often considered to be the activities of its partners. Accordingly, the ruling states that, "the activities of an LLC treated as a partnership for federal income tax purposes are considered to be the activities of a nonprofit corporation that is an owner of the LLC when evaluating whether the nonprofit organization is operated exclusively for exempt purposes within the meaning of section 501(c)(3)." Even more importantly, the ruling advises that if a private party is allowed to control or use a nonprofit organization's activities or assets (presumably including activities and assets owned by a partnership in which the nonprofit is a partner) for the benefit of the private party and the benefit is not incidental to the accomplishment of exempt purposes, then the organization will fail to be organized and operated exclusively for such purposes.

Based upon these principles, not surprisingly the ruling holds that the organization in situation one is furthering its charitable purposes by becoming a member of the LLC, while the organization in situation two fails to satisfy the "operational test" by virtue of its participation in the LLC. In particular, in situation one, because the organization controls the governing body of the LLC, and because the LLC's governing instruments put charitable purposes ahead of economic profit if the two goals conflict, the organization in the first situation can ensure that 1) the LLC will operate in furtherance of the organization's charitable purposes and 2) the benefit to the for-profit will be "incidental" to the accomplishment of those purposes. In contrast, in situation two, the absence of

1. control of the LLC governing body by the organization;

2. a statement in the organizational documents that charitable purposes will override profit-oriented goals when the two conflict; and

3. an independent management company whose entitlement to provide services is for a reasonable period of time, drives the conclusion that the organization in the second situation has failed to establish it is neither organized nor operated for the benefit of private interests.

Redlands Surgical Services and St. David's Health Care

The Tax Court of the United States confronted what was essentially a "whole hospital joint venture" in Redlands Surgical Services v. Commissioner, 113 T.C. 47 (1999), aff'd per curiam, 242 F.3d 904 (9th Cir. 2001). In that case, a tax-exempt subsidiary of a nonprofit hospital system, with a for-profit corporation, entered into a general partnership (the "general partnership") that acquired a 61 percent partnership interest in a pre-existing ambulatory surgery center (the "operating partnership"). The exempt subsidiary's ownership of a partnership interest and participation in the operation of the surgery center constituted its only business activity.

The court made it abundantly clear that retaining control over its exempt activity of providing health care to the Redlands, California, community was critical to preserving the subsidiary's tax-exempt status. Thus, after confirming that the "aggregate" theory of partnership taxation applied for purposes of treating the activities of the operating partnership as the operations of the exempt subsidiary, the court stated that:

"[T]o the extent that petitioner cedes control over its sole activity to for-profit parties having an independent economic interest in the same activity and having no obligation to put charitable purposes ahead of profit-making objectives, petitioner cannot be assured that the partnerships will in fact be operated in furtherance of charitable purposes. In such a circumstance, we are led to the conclusion that petitioner is not operated exclusive for charitable purposes" [113 T.C. at 78].

In finding that the tax-exempt subsidiary had, in fact, lost the ability to ensure that the operating partnership would act exclusively in furtherance of charitable purposes, the court relied upon the facts that

1. nothing in the general partnership agreement put charitable purposes ahead of profit-making objectives;

2. while the exempt subsidiary effectively had veto power under the general partnership agreement by virtue of equal voting rights with its for-profit partner, the exempt organization could not "initiate action" to better serve the Redlands community's health needs;

3. the operating partnership entered into a management contract with an affiliate of the for-profit partner that was for at least 15 years and also did not obligate the affiliate to further charitable purposes ahead of profit-making goals;

4. the exempt subsidiary could not show that it exercised informal control over the ambulatory surgery center; and

5. the exempt subsidiary even agreed to a noncompete agreement that gave the for-profit a competitive advantage in the Redlands market.

The focus of the court's analysis was plainly not on the actual operations of the surgery center, but rather on whether the tax-exempt subsidiary could, through control rights, ensure that economic objectives would always be subordinated to charitable purposes. The United States Court of Appeals for the Ninth Circuit affirmed the Tax Court's opinion on the basis that "Redlands Surgical Services 'has ceded effective control over the operations of the partnerships and the surgery center to private parties, conferring impermissible private benefit.'" 242 F.3d at 904.

In St. David's Health Care, a tax-exempt hospital system located in Austin, Texas, entered into a partnership agreement with health care giant Columbia/HCA Health Care Corporation, a for-profit company that operates 180 hospitals nationwide. St. David's contributed all of its hospital facilities to the partnership and HCA, in turn, contributed its Austin-area facilities. The partnership then hired a subsidiary of HCA to manage the day-to-day operations of the partnership's medical facilities. Under the partnership agreement, each of St. David's and HCA appointed three members to the partnership's board of governors and a majority of each partner's members on the board was required for action to be taken.

At the trial court level, St. David's was granted summary judgment that its participation in the partnership with HCA did not adversely affect its tax-exempt status. On appeal by the government to the U.S. Court of Appeals for the Fifth Circuit, however, St. David's was not as successful. Echoing the thinking of the Tax Court and Ninth Circuit in the Redlands case regarding the importance of retention of control, the Fifth Circuit stated that, "When the nonprofit organization cedes control over the partnership to the for-profit entity, we assume that the partnership's activities substantially further the for-profit's interest." On the other hand, "if the nonprofit organization enters into a partnership agreement with a for-profit entity, and retains control, we presume the non-profit's activities by the partnership primarily further exempt purposes." After expressing some doubt as to whether St. David's did retain the requisite control over the partnership, the Fifth Circuit remanded the case back to the U.S. District Court for further proceedings consistent with its opinion.

The Fifth Circuit's concerns about whether St. David's effectively controlled the partnership's operations were based on several factors. First, because the board of governors could not act without approval of a majority of each partner's representatives on the board, St. David's only had veto rights as to board decisions, but could not initiate at the board level action to further charitable purposes. Second, because the management company was a for-profit subsidiary of HCA, the court thought it more likely than not that the manager would prioritize the "presumably noncharitable" interests of its parent organization. Third, while St. David's appointed the initial CEO of the partnership, the court was concerned by the fact that St. David's never took any punitive action against the CEO even though he failed to prepare annual reports on charity care as required by the partnership agreement. And lastly, while St. David's argued that it controlled the partnership by virtue of its authority to dissolve the partnership if it did not further charitable goals, the court emphasized that dissolution clearly was not in the best interests of St. David's because of the noncompete agreement it had signed with HCA.

On remand back to the District Court, a jury trial was held and the jury found in favor of St. David's. This taxpayer favorable verdict was significant because the District Court judge instructed the jury that whether St. David's was entitled to tax-exempt status turned on whether it retained sufficient control over partnership operations to ensure that those operations primarily furthered charitable purposes, and that no more than an insubstantial amount of the partnership's activities furthered non-exempt purposes. In light of this jury instruction, rather than appeal the verdict, the IRS chose to enter into a settlement agreement with St. David's in which the organization kept its tax-exempt status. Tax-exempt organizations cannot take great comfort from this taxpayer victory, however, in part because the Fifth Circuit not only cited Rev. Rul. 98-15 extensively and stated in a footnote that the court generally accords IRS revenue rulings great weight, but because the court repeatedly compared the facts in St. David's to the facts of the ruling in order to determine whether St. David's had kept sufficient control over the partnership. What does seem clear from the Fifth Circuit's opinion is that a tax-exempt organization's lack of voting control with respect to a partnership with a for-profit does not, in and of itself, mean that the partnership is not furthering charitable goals if other mechanisms are present for ensuring that charity is put ahead of profits.

Revenue Ruling 2004-51

Most recently, the IRS published Rev. Rul. 2004-51, which deals not with the contribution by a tax-exempt organization of all or substantially all of its assets to a partnership with a for-profit partner, but rather with a partnership that represents an insubstantial part of a tax-exempt organization's overall activities. In that ruling, M is a tax-exempt university that offers summer seminars to enhance the skill level of elementary and secondary school teachers. O, on the other hand, is a for-profit company that specializes in conducting interactive video training programs. M and O organize L, a limited liability company taxed as a partnership, whose sole purpose is to offer teacher training seminars at off-campus locations using interactive video technology. L is not only owned equally by M and O, but the two members make equal capital contributions to L, are entitled to equal distributions from L, if any, and have equal representation on L's governing board.

L's governing documents grant M the exclusive right to approve the curriculum, training materials, and instructors and to determine the standards for successful completion of the teacher training seminars. O is granted the exclusive right to select the locations where participants can receive a video link and to approve all personnel other than instructors to conduct the video training seminars. All other actions with respect to the training seminar business conducted by L require mutual consent. However, L's governing documents further provide that

1. all contracts and transactions between the members, between L and each of the members and with respect to third parties must be at arm's length for fair market consideration;

2. L may not engage in any activity that would jeopardize M's exemption under section 501(c)(3); and

3. L may only conduct teacher training seminars. Importantly, the ruling states that M's participation in the partnership will be "an insubstantial part" of M's activities within the meaning of the regulations under Section 501(c)(3) of the code.

This ruling does not discuss whether M does or does not have control over L's operations. Instead, the IRS merely holds that because the activities of M that are treated as being conducted through L are "not a substantial part of M's activities," by definition, M's participation in such an "ancillary joint venture" cannot jeopardize its tax-exempt status. On the issue of whether M's share of income from L constitutes unrelated business taxable income, based on the carefully constructed facts in the ruling, the IRS finds that the activities of M conducted through L are substantially related to its exempt purposes. In particular, the ruling points to the facts that 1. M alone approves the curriculum, training materials, and instructors and determines the standards for successfully completing the seminars; 2. the teacher training seminars L conducts using interactive video technology cover the same content as the seminars M conducts on its campus; and 3. L's activities, in fact, actually expand the reach of M's teacher training seminars to individuals who might not otherwise be able to obtain such training on campus.

Lessons learned

Based on the foregoing rulings and court decisions, certain basic principles can be discerned that govern whether or not a tax-exempt organization's participation in a partnership with a for-profit entity will adversely affect its tax-exempt status. First, in light of Rev. Rul. 2004-51, an organization's participation in such a partnership whose activities represent an insubstantial part of the organization's overall operations will not jeopardize the organization's exempt status provided the legal relationships with respect to the partnership are on an arm's-length basis, even if the organization does not control the operations of the partnership. In fact, at a recent American Bar Association function, a representative of the IRS stated that voting control is not important to the analysis if the partnership's activities are not substantial in relationship to the tax-exempt organization's overall business.

Second, it is becoming abundantly clear that if an exempt organization does contribute all or substantially all of its assets to a partnership with a for-profit partner, the organization must retain at least sufficient control to ensure that the partnership will, when push comes to shove, promote charitable purposes ahead of profit-making objectives. Indeed, whether such a partnership is, in fact, actually operated exclusively for charitable purposes is seemingly not as important as whether the tax-exempt partner can, as a practical matter, ensure that charitable goals always drive important operating decisions. In that regard, not only must the governing body of the partnership be obligated to act in a way that puts charitable purposes ahead of economic concerns, but the day-to-day management of the operations of such a partnership must also adhere to a similar standard. In light of these principles, participants in the tax-exempt community will continue to struggle with how to reconcile a tax-exempt organization's need for for-profit capital, with the legitimate concerns of a for-profit partner to meet its obligation to its shareholders of maximizing profits.

Howard Solodky is a tax attorney in the Washington, D.C., office of with Womble Carlyle Sandridge & Rice, PLLC. Contact Howard Solodky here.

Copyright 2004 Howard Solodky

Republished with permission, copyright August 2004, American Society of Association Executives, Washington, D.C.