Joint venture to construct and operate an elder-care facility.

In Letter Ruling 9518014, the Service considered tax exemption and unrelated business tax issues when a tax-exempt Sec. 501 (c) (3) hospital participated in a 50/50 joint venture with a for-profit company to construct and operate an elder-care facility.

The for-profit partner had experience in developing, designing and operating elder-care facilities. Each partner contributed capital and shared equally in the profits and losses of the joint venture. The joint venture was managed by a board of seven directors composed of three persons appointed by the hospital partner, three persons appointed by the for-profit partner, and one person elected by the affirmative vote of five of the six appointed directors.

The joint venture had a development agreement with the for-profit partner, with the development fee capped at a specified dollar amount. The for-profit partner also licensed the exclusive right to use its trademark to the joint venture, for an annual royalty based on the joint venture's adjusted gross revenues (subject to minimum and maximum dollar amounts)

The for-profit partner was obligated to obtain and guarantee the construction and permanent bank financing for the venture. The hospital lent to the joint venture one-fourth of its initial funding at a fair market interest rate and its liability was limited to its loan plus its equity capital contribution.

The hospital believed that in the future it would have to convert its loan into an equity interest in the joint venture in order to secure permanent financing for the facility following its construction. When that occurred, the organization would retain the right to receive a priority return on the equity capital contribution plus any cumulative unpaid prior year priority return. After distribution of all past and current priority returns, the hospital and the for-profit partner would share equally in the joint venture's profits and losses.

The for-profit partner was to manage the facility under a management agreement for a fee equal to a percentage of the venture's adjusted gross revenues. After the facility operated for a specified number of years, the hospital had the right to purchase the for-profit partner's interest. If the right was not exercised, the for-profit partner would have the reciprocal right as of the following year to purchase the hospital's interest. The hospital also had the right to buy the for-profit partner's interest or sell its interest to the for-profit partner in the event of a major dispute between the parties.

The IRS ruled that the participation of the hospital in the joint venture, including the loan for initial capitalization, would not jeopardize the organization's exempt status. Further, the profits and losses received by the hospital as a partner in the joint venture would be income substantially related to the hospital's exempt purpose, and thus would not be taxed as unrelated business income. Finally, the conversion of the hospital's loan to the venture into an equity capital contribution with a preferred rate of return and priority distribution would not alter the hospital's Sec. 501 (c) (3) status.

In arriving at these conclusions, the Service reasoned that the hospital's agreement with the for-profit partner furthered its exempt purposes by providing for the housing, health, safety and financial needs of the elder community. The facility was intended to be operated under the philosophy that guided the exempt entity. Although the hospital would not manage the facility on a day-to-day basis, it retained equal control over major policies and decisions. In the facility, resident beds were to be set aside at a substantially lower rate so that the indigent segment of the community could make use of the facility. At the end of the partnership, the hospital would have learned how to successfully develop and operate an elder-care facility that in the future it could employ expertise in its existing facility or n ones.

The IRS also determined that arrangement did not cause any earnings or benefits to inure to private parties. All financial arrangements we made on an arm's-length basis. Allocations of profits, losses and distributions from the venture would be proportionate to the interests of the partners.

From Phillip G. Royalty, Esq., Washington, D.C.