In recent years, as trade and professional associations have searched for additional sources of revenue and new ways to serve members' needs, some have turned to partnerships or joint ventures with for-profit entities as a source of needed funds or to satisfy capital requirements. In other sectors of the nonprofit community, particularly in the health care field, there has been a proliferation of partnerships and joint ventures between tax-exempt and for-profit entities.
While such arrangements have become more sophisticated over the years - such as the trend to use limited liability companies ("LLCs") as the preferred legal form of the venture - the underlying concerns with respect to these arrangements remain largely unchanged: (i) whether a tax-exempt organization's participation might adversely affect its tax-exempt status; and (ii) whether such participation results in unrelated business income to the tax-exempt organization.
With respect to the first concern, the organization's tax-exempt status is put at potential risk through (a) the fact that the organization may no longer be operated principally in furtherance of its tax-exempt purposes (depending upon the express purposes and goals of the partnership, the extent of the organization's control over the partnership, etc.), and (b) the fact that the organization may be subjecting its assets (the partnership investment) to risks for the benefit of its for-profit partner(s), thereby raising private inurement and private benefit concerns.
However, an organization's tax exemption generally will not be jeopardized if the organization continues to devote the principal share of its time, expense and other resources to the furtherance of its tax-exempt purposes. In such event, though, the organization's income from a joint venture or partnership that is not in furtherance of such purposes will be subject to unrelated business income tax ("UBIT").
Note that joint ventures and partnerships are governed by the same legal principles. A joint venture typically is an ad hoc, one-time grouping that concerns itself with a single transaction or an isolated enterprise. Unlike a partnership, a joint venture usually does not entail a long-term relationship among the parties. However, a joint venture is treated as a partnership for federal income tax purposes. For purposes of this discussion, the term "joint venture" is used to describe both joint ventures and partnerships between tax-exempt and for-profit entities.
Tax Treatment of Partnerships and Joint Ventures
As a "pass-through" entity, a partnership, as such, is not subject to tax. However, the partners are liable for income tax in their separate capacities. In determining their income tax liabilities, generally the partners take into account separately their distributive share of the partnership's income, gains, losses, etc.
Also, the character of any item of income, gain, loss, deduction, or credit included in a partner's distributive share is determined as if the item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership. In other words, if an association is a member of a partnership, it must treat its share of the partnership income in the same manner as if it had engaged in the activity (that gave rise to the income) directly. Thus, the usual UBIT exclusions (such as for interest and dividend income, royalties, capital gains, and certain real estate rental income) are available even when earned by the partnership.
Finally, a partner's distributive share of income, gain, loss, deduction, or credit generally is determined by the partnership agreement.
Joint Ventures Involving Entire Organizations
The principal focus of recent Internal Revenue Service ("IRS") enforcement efforts in the area of joint ventures has concerned the structure of health care organizations. In particular, the focus has been on joint ventures where tax-exempt hospitals transfer, in one form or another, all of their assets to joint ventures with for-profit entities and then continue to operate, to varying extents, for charitable purposes. The IRS has questioned whether these "whole hospital" joint ventures jeopardize the hospitals' tax-exempt status. The IRS and the U.S. Tax Court have stated that the key to whether the hospitals' tax-exempt status is jeopardized is operational control over the joint venture - specifically, voting control (either majority control of the governing body of the venture or veto authority over actions believed to not further charitable purposes) and ensuring through the venture's organizational documents (e.g., LLC or partnership agreement) that charitable purposes drive all decision-making of the venture (an obligation to put charitable objectives ahead of non-charitable ones).
In addition, even if the tax-exempt organization retains the requisite control over the venture, it is important that the terms do not overly favor the for-profit partner, such as excessive profits paid to the for-profit entity. While for-profit partners rightly expect a return on their investment, that private gain cannot be substantial when compared to the public benefit derived from the venture. This having been said, operational control by the tax-exempt organization remains the key factor in evaluating whether tax exemption is jeopardized by participating in a joint venture involving an organization's entire operations.
What is less clear is whether the same rule applies in the case of joint ventures involving an individual activity rather than the entire operations of the tax-exempt organization. It is this variety of joint venture that is most common in the association community.
Joint Ventures Not Involving Entire Organizations
Associations frequently enter into joint ventures with for-profit partners to conduct a particular activity. These ventures should not jeopardize the association's tax-exempt status in most cases - even if the association does not maintain operational control over the venture - because the association will still carry on substantial tax-exempt activities. Rather, the question in these cases is whether the income from them is subject to UBIT.
UBIT applies to joint venture activities as though the joint venture did not exist. Each portion of the association's joint venture income is tested under the general rules that would apply if the association engaged in the activity directly (e.g., the standard three-prong UBIT test, the exclusions for passive income sources). In other words, the association must treat its share of the joint venture income in the same manner as if it had conducted the activity in its own capacity.
There have been no reported cases to date in which the IRS has argued that lack of sufficient control over a partnership or joint venture causes an otherwise "related" activity to be subject to UBIT. However, IRS officials have indicated publicly that an analysis under the precedent for whole hospital joint ventures could lead to that result.
While this remains an open issue, if an association is considering a joint venture with a for-profit partner that is in furtherance of its tax-exempt purposes and it seeks to avoid UBIT, it should attempt to establish operational control over the venture. As stated above, control can consist of a majority of the members of the governing body, veto authority over the actions that the association believes to not further its tax-exempt purposes, and/or ensuring through the venture's organizational documents (e.g., LLC or partnership agreement) that the association's tax-exempt purposes drive all decision-making of the venture (an obligation to put tax-exempt objectives ahead of non-exempt ones).
In addition, it is important to ensure that the terms of the joint venture do not overly favor the for-profit partner, such as excessive profits paid to the for-profit entity. This is important in order to avoid the risk of private inurement or private benefit.
If the income generated by the venture will be subject to UBIT in any event - because the venture consists of providing "particular services" to members or is not otherwise substantially related to the association's tax-exempt purposes - associations should consider utilizing a taxable subsidiary to hold the ownership interest in the joint venture. The income would be taxed in the same manner as if held by the association directly, and the after-tax profits could be distributed from the subsidiary to the association in the form of tax-free dividends. Most importantly, a taxable subsidiary can serve to insulate the parent association from any challenge to its tax-exempt status and insulate the association's assets from any potential liabilities.
While such arrangements have become more sophisticated over the years - such as the trend to use limited liability companies ("LLCs") as the preferred legal form of the venture - the underlying concerns with respect to these arrangements remain largely unchanged: (i) whether a tax-exempt organization's participation might adversely affect its tax-exempt status; and (ii) whether such participation results in unrelated business income to the tax-exempt organization.
With respect to the first concern, the organization's tax-exempt status is put at potential risk through (a) the fact that the organization may no longer be operated principally in furtherance of its tax-exempt purposes (depending upon the express purposes and goals of the partnership, the extent of the organization's control over the partnership, etc.), and (b) the fact that the organization may be subjecting its assets (the partnership investment) to risks for the benefit of its for-profit partner(s), thereby raising private inurement and private benefit concerns.
However, an organization's tax exemption generally will not be jeopardized if the organization continues to devote the principal share of its time, expense and other resources to the furtherance of its tax-exempt purposes. In such event, though, the organization's income from a joint venture or partnership that is not in furtherance of such purposes will be subject to unrelated business income tax ("UBIT").
Note that joint ventures and partnerships are governed by the same legal principles. A joint venture typically is an ad hoc, one-time grouping that concerns itself with a single transaction or an isolated enterprise. Unlike a partnership, a joint venture usually does not entail a long-term relationship among the parties. However, a joint venture is treated as a partnership for federal income tax purposes. For purposes of this discussion, the term "joint venture" is used to describe both joint ventures and partnerships between tax-exempt and for-profit entities.
Tax Treatment of Partnerships and Joint Ventures
As a "pass-through" entity, a partnership, as such, is not subject to tax. However, the partners are liable for income tax in their separate capacities. In determining their income tax liabilities, generally the partners take into account separately their distributive share of the partnership's income, gains, losses, etc.
Also, the character of any item of income, gain, loss, deduction, or credit included in a partner's distributive share is determined as if the item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership. In other words, if an association is a member of a partnership, it must treat its share of the partnership income in the same manner as if it had engaged in the activity (that gave rise to the income) directly. Thus, the usual UBIT exclusions (such as for interest and dividend income, royalties, capital gains, and certain real estate rental income) are available even when earned by the partnership.
Finally, a partner's distributive share of income, gain, loss, deduction, or credit generally is determined by the partnership agreement.
Joint Ventures Involving Entire Organizations
The principal focus of recent Internal Revenue Service ("IRS") enforcement efforts in the area of joint ventures has concerned the structure of health care organizations. In particular, the focus has been on joint ventures where tax-exempt hospitals transfer, in one form or another, all of their assets to joint ventures with for-profit entities and then continue to operate, to varying extents, for charitable purposes. The IRS has questioned whether these "whole hospital" joint ventures jeopardize the hospitals' tax-exempt status. The IRS and the U.S. Tax Court have stated that the key to whether the hospitals' tax-exempt status is jeopardized is operational control over the joint venture - specifically, voting control (either majority control of the governing body of the venture or veto authority over actions believed to not further charitable purposes) and ensuring through the venture's organizational documents (e.g., LLC or partnership agreement) that charitable purposes drive all decision-making of the venture (an obligation to put charitable objectives ahead of non-charitable ones).
In addition, even if the tax-exempt organization retains the requisite control over the venture, it is important that the terms do not overly favor the for-profit partner, such as excessive profits paid to the for-profit entity. While for-profit partners rightly expect a return on their investment, that private gain cannot be substantial when compared to the public benefit derived from the venture. This having been said, operational control by the tax-exempt organization remains the key factor in evaluating whether tax exemption is jeopardized by participating in a joint venture involving an organization's entire operations.
What is less clear is whether the same rule applies in the case of joint ventures involving an individual activity rather than the entire operations of the tax-exempt organization. It is this variety of joint venture that is most common in the association community.
Joint Ventures Not Involving Entire Organizations
Associations frequently enter into joint ventures with for-profit partners to conduct a particular activity. These ventures should not jeopardize the association's tax-exempt status in most cases - even if the association does not maintain operational control over the venture - because the association will still carry on substantial tax-exempt activities. Rather, the question in these cases is whether the income from them is subject to UBIT.
UBIT applies to joint venture activities as though the joint venture did not exist. Each portion of the association's joint venture income is tested under the general rules that would apply if the association engaged in the activity directly (e.g., the standard three-prong UBIT test, the exclusions for passive income sources). In other words, the association must treat its share of the joint venture income in the same manner as if it had conducted the activity in its own capacity.
There have been no reported cases to date in which the IRS has argued that lack of sufficient control over a partnership or joint venture causes an otherwise "related" activity to be subject to UBIT. However, IRS officials have indicated publicly that an analysis under the precedent for whole hospital joint ventures could lead to that result.
While this remains an open issue, if an association is considering a joint venture with a for-profit partner that is in furtherance of its tax-exempt purposes and it seeks to avoid UBIT, it should attempt to establish operational control over the venture. As stated above, control can consist of a majority of the members of the governing body, veto authority over the actions that the association believes to not further its tax-exempt purposes, and/or ensuring through the venture's organizational documents (e.g., LLC or partnership agreement) that the association's tax-exempt purposes drive all decision-making of the venture (an obligation to put tax-exempt objectives ahead of non-exempt ones).
In addition, it is important to ensure that the terms of the joint venture do not overly favor the for-profit partner, such as excessive profits paid to the for-profit entity. This is important in order to avoid the risk of private inurement or private benefit.
If the income generated by the venture will be subject to UBIT in any event - because the venture consists of providing "particular services" to members or is not otherwise substantially related to the association's tax-exempt purposes - associations should consider utilizing a taxable subsidiary to hold the ownership interest in the joint venture. The income would be taxed in the same manner as if held by the association directly, and the after-tax profits could be distributed from the subsidiary to the association in the form of tax-free dividends. Most importantly, a taxable subsidiary can serve to insulate the parent association from any challenge to its tax-exempt status and insulate the association's assets from any potential liabilities.