Tax-exempt and commercial organization joint ventures.

The Internal Revenue Service recently provided valuable guidance for tax-exempt organizations regarding joint ventures with commercial business entities. In Revenue Ruling 2004-51, the IRS concluded that a tax-exempt organization's participation in a joint venture did not jeopardize the organization's tax-exempt status because the character of the joint venture activity remained consistent with the organization's tax-exempt purpose. Though the ruling cannot be viewed as legal precedent, the analysis provides much-needed clarity to the confusing area of ancillary joint ventures between and among tax-exempt organizations and for-profit entities. In this column, Lauren Bright explains the ruling and its implications.

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Recent Internal Revenue Service Ruling 2004-51 concluded that the tax-exempt status of a nonprofit organization engaged in a joint venture with a for-profit company is not jeopardized as long as the shared activities are consistent with the tax-exempt purposes of the nonprofit entity. Background information and a discussion of the IRS ruling provide additional information for associations considering--or already engaged in--such activity.

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Types of joint ventures

A joint venture is essentially a partnership between or among two or more parties whereby each party contributes a portion of its assets, expertise, or activities for the purpose of performing a specific business transaction. Depending on the degree of involvement of the exempt organization, there are four types of joint ventures that may come into play:

1. Ancillary joint ventures involve a limited portion of the assets or services of an exempt organization.

2. Whole joint ventures involve all or substantially all of the assets of an exempt organization.

3. Exempt-only joint ventures involve the assets or services of two or more exempt organizations.

4. Investment-type joint ventures involve the participation of an exempt organization in a limited or passive capacity.

The first type, the ancillary joint venture, is the subject of the ruling. However, regardless of the type, joint ventures between tax-exempt organizations and for-profit entities are highly scrutinized by the IRS because of the concern that such ventures will not contribute to one or more of the exempt organization's purposes.

Prior rulings on joint ventures

In general, prior rulings addressing joint ventures between tax-exempt organizations and for-profits have indicated that if a tax-exempt organization cedes control to its for-profit partner, the tax-exempt organization will lose exempt status for its share of the income. Indeed, the organization's entire exemption would be at risk if the income is substantial. For example, in a case involving Redlands Surgical Services, the Ninth Circuit Court of Appeals held that a tax-exempt entity must maintain effective control of partnership activities. Examples of such control include majority voting power, independent management of the joint venture, or other measures ensuring that partnership operations are conducted primarily for charitable purposes. If the exempt entity does not maintain control, the activities of the partnership will be deemed to serve private, and not public, interests.

Similarly, in St. David's Health Care System v. United States, the Fifth Circuit held that the determination of whether a nonprofit organization that enters into a partnership operates exclusively for exempt purposes is not limited to whether the partnership provides charitable services. To maintain tax-exempt status, the tax-exempt entity must have some means of ensuring that the partnership's operations further charitable purposes. According to that ruling, an organization will "lose its tax-exempt status if it cedes control to the for-profit entity."

As a result of these rulings, it was long believed that tax-exempt entities could not enter joint ventures with for-profit entities on a 50-50 basis without risking the loss of tax-exempt status. Accordingly, such ventures have traditionally been structured so that the tax-exempt organization maintains a majority of shares in the venture and control over the board of directors. The recent IRS guidance, however, provides tax-exempt organizations increased latitude in structuring such ventures.

Revenue Ruling 2004-51

In Revenue Ruling 2004-51, a tax-exempt university and a for-profit corporation formed a limited liability company to expand the university's teacher training seminars to off-campus locations using interactive video technology. Both the university and the corporation owned an equal 50 percent share of the LLC, and each entity appointed three individuals to the LLC's six-member board of directors. With respect to structure, responsibilities were divided between the two entities. The university had exclusive authority to approve curriculum, training materials, instructors, and the standards for successful completion of the educational programs. The LLC had exclusive authority over all aspects of the video teacher training seminars, including advertising, enrolling participants, selecting program locations, and distributing course materials. The governing documents of the LLC further provided that all contracts and transactions to be entered by the LLC were to be at arm's length and for fair market value, and the LLC was not to engage in any activity that would jeopardize the university's tax exemption under Section 501(c)(3).

Upon review by the IRS, the university's joint venture raised two issues. The primary issue was whether the university jeopardized its tax-exempt status by contributing a portion of its assets to and conducting a portion of its activities through the LLC. The IRS determined that the university's activities conducted through the LLC constituted a trade or business substantially related to the university's exempt purposes and functions. Therefore, notwithstanding the fact that the corporation arranged and conducted the teacher training seminars, the university retained exclusive authority over the educational aspects of the program. Moreover, the video teacher training seminars covered the same content as seminars conducted on the university's campus. As such, the programs were in keeping with the university's exempt purposes, as they merely expanded the scope of the university's current educational activities.

A secondary issue was whether the university would have to pay unrelated business income tax on revenues earned from the LLC. Because it was concluded that the activities of the LLC were substantially related to the university's exempt purposes, the IRS determined that the revenues received by the university from the activities of the LLC were not subject to UBIT.

Implications for associations

Joint ventures between tax-exempt organizations and for-profit entities can lead to unfavorable tax implications for the exempt organization, including disqualification from tax exemption, if the venture is not structured in accordance with IRS rules and regulations. As a result of Ruling 2004-51, it appears that "control" of the entire venture is no longer essential. As such, tax-exempt organizations will now likely have the option of participating in bifurcated joint ventures without jeopardizing tax-exempt status, as long as the exempt organization controls the substantive, exemption-related aspects of the venture. However, notwithstanding the much-needed guidance, tax-exempt organizations should continue to proceed with caution when engaging in joint ventures, partnerships, or similar arrangements with commercial businesses.

EDITED BY JERALD A. JACOBS

LAUREN W. BRIGHT

Lauren W. Bright is an attorney with the Nonprofit Organizations Practice and Jerald A. Jacobs is a partner at the law firm of Shaw Pittman, Washington, D.C. Jacobs edits this column and is general counsel to ASAE.