Whole-hospital joint ventures.

In Rev. Rul. 98-15, the IRS provides guidance on structuring health care joint ventures between an exempt hospital and a taxable organization, without endangering the hospital's tax-exempt status. While Rev. Rul. 98-15 reinforces prior rulings and case law analysis, it also states that a charity can enter into a partnership and not lose its exempt status. In addition, the ruling is a clear statement that a relationship with a limited liability company (LLC) is acceptable. In Rev. Rul. 98-15, the Service presents two situations in which a hospital forms a joint venture with a taxable organization and analyzes whether the ownership structure, along with a management agreement with the joint venture, allow the hospital to continue to qualify for exemption under Sec. 501(c)(3).

In previous cases (e.g., Plumstead Theatre Society, Inc., 74TC 1324 (1980), and Housing Pioneers, TC Memo 1993120), the Tax Court held that an organization may form and participate in a partnership and meet the operational tests if participation in the partnership furthers a charitable purpose. The partnership arrangement must permit the exempt organization to act exclusively to further its exempt purpose and only incidentally for the benefit of its for-profit partners.

The courts have also ruled that a Sec. 501(c) (3) organization may enter into a management contract with a private party that gives that party authority to conduct activities on the exempt organization's behalf and direct the use of its assets, provided the organization retains ultimate authority over the assets and activities being managed and the contract's terms and conditions are reasonable (including reasonable compensation and a reasonable term). However, if a party controls or uses the nonprofit organization's activities or assets for its benefit and the benefit is not incidental to the accomplishment of the exempt purposes, the organization fails to be organized and operated exclusively for exempt purposes.

Although Rev. Rul. 98-15 does not provide safe harbors for these types of joint ventures, it does imply that the following conditions must be met for a hospital to comply with the operational test. The governing documents of the joint venture should provide for the entity to be managed by a governing board consisting of a majority of individuals chosen by the tax-exempt hospital. These individuals must not be on the hospital staff and should not engage in any transactions with the hospital. The governing documents should provide that they can be amended only with the approval of both owners of the joint venture, and that a majority of board members has to approve major decisions relating to the joint venture's operation, including decisions relating to:

* Annual capital and operating budgets;

* Distribution of earnings;

* Selection of key executives;

* Acquisition or disposition of health care facilities;

* Contracts in excess or a certain dollar amount per year;

* Changes to the types of services offered; and

* Renewal or termination of management agreements.

The governing documents should explicitly provide that the duty of the members of the joint venture's governing board is to operate the entity in a manner that furthers charitable purposes by promoting health for a broad cross-section of the community, which overrides any duty the members may have to operate it for the financial benefit of its owners.

If there is ever a conflict between operation in accordance with the community benefit standard and any duty to maximize profits, the members of the governing board should satisfy the community benefit standard without regard to the consequences for maximizing profitability.

The governing documents should provide that all returns of capital and distributions of earnings to the owners of the joint venture will be in proportion to their ownership interest in the joint venture. The terms of the governing documents should be legal, binding and enforceable under applicable state law.

If the joint venture enters into a management agreement, the terms and conditions of such agreement should be reasonable and comparable to what other management firms receive for similar services at similarly situated hospitals. The joint venture should be able to terminate the agreement for cause.

None of the officers, directors or key employees of the hospital involved with the decision to form the joint venture should be promised employment or any other inducement. None of the hospital's officers, directors or key employees should have any interest in the taxable entity or any of its related entities. This includes interests owned through the Sec. 318 attribution rules.

In Rev. Rul. 98-15, the hospital intended to use distributions from the joint venture to make grants to support activities that promote the health of the hospital's community and to help the indigent obtain health care. Substantially all of the hospital's grant-making was to be funded by distributions from the joint venture. The hospital's grant-making program and its participation as an owner of the joint venture constituted its only activities.

Rev. Rul. 98-15 gives two examples to illustrate whether the joint venture entered into with a taxable organization and the management agreement represented private benefit.

Example 1: A tax-exempt acute care hospital decides that it could better serve its community if it obtained additional funding. A taxable organization indicates it is interested in providing this financing if it can earn a reasonable rate of return on its investment. The two entities form a joint venture in the form of an LLC. The hospital contributes all of the assets, including its hospital building and equipment, to the joint venture. The taxable entity also contributes assets to the joint venture. In return, both the hospital and the taxable organization receive ownership interests in the joint venture proportional and equal in value to their respective contributions.

The governing documents, of the joint venture provide that it is to be managed by a governing board consisting of three individuals chosen by the hospital and two individuals chosen by the taxable organization. The individuals chosen by the hospital are community leaders who have experience with hospital matters, but are not on the hospital staff and do not have any business transactions with the hospital.

In addition, the governing documents provide that they can only be amended with the approval of both owners; a majority of three board members must approve certain major decisions about the joint venture's operation, including decisions relating to:

1. The joint venture's annual capital and operating budgets;

2. Distributions of the joint venture's earnings;

3. Selection of key executives;

4. Acquisition or disposition of health care facilities;

5. Contracts in excess of a certain dollar amount;

6. Changes to the types of services offered by the hospital; and

7. Renewal or termination of management agreements.

The governing documents further require that the joint venture may operate any hospital it owns in a manner that furthers charitable purposes by promoting health for a broad cross-section of the community. These documents explicitly state that it is the board members' duty to operate the LLC in a manner that furthers the charitable purposes by promoting health for a broad cross-section of the community, overriding any duty it may have to operate for the owners' financial benefit. In the event of a conflict between the two, the board must satisfy the community benefit standard without consequences for maximizing the joint venture's profitability. All returns of capital and any distributions must be in proportion to the parties' ownership interests.

The joint venture entered into a management agreement with an independent management company to provide day-to-day management services over a five-year term. The agreement is renewable for additional five-year periods by the parties' mutual consent. The management fee is based on the joint venture's gross revenues. The joint venture can terminate the management agreement for cause. None of the officers, directors or key employees of the hospital involved in forming the joint venture were promised employment or any other incentive by the joint venture or by the taxable entity to approve the transaction.

The hospital intends to use any distributions it receives from the joint venture to provide grants to support activities that promote the health of the hospital's community and to help the indigent obtain healthcare. Substantially all of the hospital's grantmaking will be funded by distributions from the joint venture. The hospital's projected grantmaking program and its participation as an owner of the joint venture will be its only activities.

IRS position: The hospital had established that it would be operating exclusively for a charitable purpose and only incidentally for the purpose of benefiting the private interests of the taxable organization. Because the charitable organization's grantmaking activities were contingent on the receipt of distributions from the LLC, its principal activity would continue to be the provision of hospital care. Therefore, the hospital would continue to be classified as a tax-exempt organization under. Sec. 501(c)(3) after the joint venture was formed.

Example 2: The facts are the same as in Example 1, except that the governing board of the joint venture is made up of equal members of both the hospital and the taxable organization. The decisions relating to the joint venture's operations must be approved by a majority of board members and include annual capital and operating budgets; distributions over a required minimum level, as set forth in the operating agreement; unusually large contracts; and selection of key individuals. The governing documents provide that the joint venture's purpose is to construct, develop, own, manage, operate and take other action in connection with operating the health care facility it owns and engage in other health care-related activities.

Similar to Example 1, the joint venture enters into a management agreement with a wholly owned subsidiary of the taxable entity to provide day-to-day management services. This agreement is renewable for additional five-year periods at the discretion of the for-profit subsidiary, and the joint venture may terminate the agreement only for cause. As part of the agreement to form the joint venture, the hospital agrees to approve the selection of two individuals to serve as the joint venture's chief operating officer and chief financial officer. These individuals have previously worked for the for-profit entity in hospital management and have business expertise.

IRS position: Because the hospital failed to operate exclusively for exempt purposes, it violated the tax-exempt organization requirements under Sec. 501(c)(3) when it formed the joint venture. There was no binding obligation for the LLC to serve charitable purposes or otherwise provide services to the entire community; it could deny care to the poor if it chose to do so. Also, the exempt organization did not directly control the LLC, and would not be able to initiate programs within the LLC to serve new health needs within the community without the agreement of at least one member appointed by the for-profit organization.

Rev. Rul. 98-15 is only the second revenue ruling issued by the Service in the health care arena since 1986. While it provides some needed guidance, it leaves many questions unanswered. Does this ruling apply to other nonhealth care-related joint ventures? Should there be concerns about joint ventures having equal representation between the tax-exempt organization and the taxable entity? Which of the various factors in the revenue ruling carry the most weight? Will the ruling be applied retroactively?

Even with Rev. Rul. 98-15, these questions, as well as others, remain unanswered. Overall, and given the Service's position in Redlands Surgical, in which it required that control over a joint venture be maintained by the exempt organization, it continues to impose the control requirement on all joint ventures.