Alliance for Children and Families, June 15, 2004
Many Ways to Achieve Joint Ventures
But Be Aware of Tax and Exemption Issues
Back in the early 1990s, we all heard how funders were trying to force non-profit providers to work together to avoid duplication in the marketplace. The United Way led this change by insisting that some of its grants would not be approved unless more than one service provider was part of the application. These forced alliances were not always successful. The bet- ter ones either figured out how to successfully blend resources or hired consultants to help them do so.
These early joint enterprises were the beginning of a movement that has been building momentum: strategically joining forces to provide a wide range of services while remaining a “lean and mean” organization. Our practice has been involved in the front-end activities related to a number of joint ventures, and I want to share some of my observations with you.
There are many ways of joint venturing. Much of our work involves two major areas of legal advice: (1) exploring the tax ramifications of the proposed venture, and (2) drafting contracts that confirm the parties’ agreement and establish their future relationship.
Joint Venture Combinations
Perhaps it’s best to start by describing what a joint venture is not. Outsourcing a task by bringing in an outside vendor is not a joint venture. When a residential treatment center contracts out its food preparation to a catering entity, or a small agency contracts for claims processing or payroll functions with a service vendor, this is a simple business deal because there is no shared enterprise.
For a joint venture to exist, there must be a community of interest in the performance of a common purpose; an ownership interest in the subject matter; a right to direct and govern; a duty, which may be altered by agreement, to share both in profit and losses; and one member of the joint enterprise is liable to third parties for acts of the other venturer, especially payment of debts.1
Most often, nonprofits will partner with other nonprofits to accomplish something that neither could do on its own. One common strategy we often see brings together two agencies to jointly construct an office building to house their operations. Or they might form a joint enterprise to engage in a business opportunity such as workforce training for jointly needed staff. These joint ventures typically are exempt from taxation because their parent organizations are exempt. However, the joint venturers may or may not be required to pay unrelated business income tax on the profits generated, depending upon whether the business activities are within or outside of their recognized exempt purposes.2
The type of joint venture I discuss in the remainder of this article is tax-exempt nonprofits joint venturing with for-profit business partners. I am going to refer to the nonprofit as an exempt organization, or EO, since my discussion will revolve around the tax ramifications under cases and rulings of the Internal Revenue Service.
The Plumstead Principle of Control
The way was paved for partnering arrangements between EOs and for-profit entities in 1980, when the U.S. Tax Court ruled that a tax-exempt theater group could partner with private investors without losing its tax exemption. In Plumstead, the EO’s exemption3 was allowed to stand because the court found that (1) the nonprofit had no obligation to return equity contributions to its investors if the play failed to break even, and (2) none of the investors had control over, or were involved in, the theater company’s day to day activities.
After Plumstead, we witnessed two decades of joint venturing that pushed the envelope of acceptable limits on nonprofit/for-profit joint venturing. The most notorious area of aggressive joint ventures involved health care organizations. In these, tax-exempt hospitals either sold all their assets to a for-profit hospital corporation and placed the sale proceeds in a grant-making foundation, or entered into “whole hospital” or “partial hospital” joint ventures in which the hospital (or a portion of it) was contributed to the joint venture and thereafter managed by a for-profit management corporation.
After the IRS successfully challenged a California whole-hospital joint venture in the mid-1990s,4 it issued Revenue Ruling 98-15 that established the rules we abide by today.5 While there are a number of factors that differentiate a “good” situation from a “bad” situation, basically, the exempt entity must maintain sufficient formal or informal control to ensure furtherance of its charitable purpose, and the joint venture must actually carry out the EO’s exempt purpose. Failure to do either may result in loss of exemption.
Types of Joint Venture Vehicles
If you intend to undertake a joint venture, be sure to structure it properly.
Partnership. If you establish a general partnership between your organization and another, you and your partner agency will typically share management responsibilities and be jointly and severally liable for the debts of the partnership. Under a limited partnership, one of the entities will be a general, or managing, partner and the rest are passive. The general partner remains liable for the debts of the partnership and the others are liable only to the extent of their actual investment.6 Partnerships are formed by a written partnership agreement.
Business Corporation. A business corporation is a separate entity that will provide com- plete protection from liability for all investor agencies. While most corporations formed by tax exempt organizations will be relatively easy to obtain an exemption for, they are not automatically exempt just because their shareholders are exempt—unless they elect under Subchapter S of the IRS Code. If they do, then the S corporation adopts the same taxpayer status as its investing organizations. Business corporations are formed by the filing of articles of incorporation, usually with your secretary of state.
Limited Liability Company. An LLC is a new entity that is very useful as a joint venture organization. It can take on the characteristics of either a business corporation or a partnership, since it is a statutory blend of both. A multiple-member LLC whose members are all exempt may elect to be treated as an exempt entity. We like to work with LLCs because they are easy to establish and flexible. Thus, we have great leeway within the operating agreement to describe responsibilities and structure relationships. LLCs are formed by the filing of articles of organization, again usually with your secretary of state.
A recent revenue ruling provides us a good example of a joint venture between an exempt organization and a for-profit business. A university that provided teacher training seminars set up a joint venture with a for-profit enterprise that specializes in conducting interactive video training programs. The university maintained total control of the curriculum, materials, and instructors while the video company maintained control over locations where participants were to receive a video link and technicians needed to produce and transmit the programs. All other decisions were to be arrived at jointly. The IRS held that this was not a substantial part of the university’s activities, and there- fore would not jeopardize its exemption. Further, it ruled that the training programs furthered the university’s mission and that the profits would therefore not be taxed as unrelated business income.
I encourage you to think creatively about how you might join forces with other organizations and businesses to carry out your mission to children and families. If you do decide to create a joint venture, be sure you structure it properly so that it will not jeopardize your tax exemption and/or generate unnecessary taxes.