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IRS
Wins Redlands Case: Joint Venture with For-Profit Disqualifies Nonprofit
for Tax Exemption
By LaVerne Woods
[Summer 1999]
In a decision with
wide-ranging implications, the Tax Court has ruled that the IRS
properly denied tax exemption under Section 501(c)(3) to a nonprofit
organization that entered into a partnership with a for-profit as
its sole activity. The nonprofit "ceded effective control" over
the partnership's activities to for-profit parties, the court found,
and conferred substantial benefits on the for-profits. It accordingly
was not operated exclusively for charitable purposes, as required
for tax exemption.
In light of Redlands,
all tax-exempt organizations should re-examine any partnerships,
limited liability companies, and corporate joint ventures with for-profit
participants. Failure to control such joint ventures could jeopardize
exemption, or at a minimum result in income from the venture being
taxed as unrelated business income.
Redlands Surgical
Services (RSS) was a newly-formed member of a health care system
that included a tax-exempt hospital. RSS owned a 46% profits interest
and controlled 50% of the board of a general partnership. A for-profit
entity owned the remaining 54% profits interest and controlled the
other 50% of the board. The general partnership, in turn, owned
a 59% interest in a second partnership that owned and operated an
ambulatory surgery center (ASC). The remaining interests in the
ASC partnership were owned by physicians. RSS maintained that its
indirect ownership interest in the ASC furthered charitable purposes
and qualified RSS for tax exemption under Section 501(c)(3).
The Tax Court looked
at all of the facts and circumstances surrounding the joint venture
in reaching its conclusion that RSS did not qualify for exemption.
The court placed special weight on the following:
- neither the general partnership agreement
nor the ASC partnership agreement expressly stated any charitable
purposes;
- RSS's 50% board representation in the
general partnership allowed it only to block actions, and not
to initiate actions without the consent of other board members;
- the general partnership agreement provided
for dispute resolution by arbitration, but the arbitrators were
not required to take into account any charitable, as opposed to
economic, objectives;
- a for-profit affiliate of the for-profit
partner in the general partnership managed the ASC under a long-term
management agreement that conferred broad powers, and did not
provide that the management would be guided by any charitable
goals;
- RSS failed to establish that its role
in the general partnership caused the ASC to operate for charitable
purposes; and
- the general partnership agreement imposed
competitive restrictions on the ability of RSS's exempt health
care affiliates to provide outpatient surgical services.
The decision states
clearly that a nonprofit organization is not per se prohibited
from entering into a joint venture with a for-profit organization
to further its charitable purposes on mutually beneficial terms.
The problem in RSS's case was that, based upon the totality of the
circumstances, the overall effect of the joint venture was to serve
private interests.
The court's facts
and circumstances approach provides some guidance on how joint ventures
with for-profits may be structured to avoid running afoul of the
tax laws. In particular, the court's analysis may leave the door
open for joint ventures in which an exempt organization and a for-profit
each have a 50% profits interest and appoint 50% of the board, but
in which the exempt organization retains substantial unilateral
powers, such as the power to initiate programs to further charitable
purposes.
Overall, the Redlands
decision seems to approve the IRS's approach to "whole hospital"
joint ventures, as set out in IRS Rev. Rul. 98-15, issued last year.
In that ruling, the IRS described two situations in which hospitals
contributed all of their assets to joint ventures with for-profit
organizations. The IRS ruled that a hospital's retention of control
over the joint venture was a key factor in the hospital retaining
its tax exemption.
In Redlands,
RSS's sole activity was its participation in the joint venture.
The effect of Redlands on ancillary joint ventures, in which
the joint venture is only a small part of the nonprofit's activities,
is unclear. Arguably, in an ancillary joint venture, if the exempt
partner fails to control the venture, the result should be only
that income from the joint venture is taxable as unrelated business
income, rather than loss of tax exemption for the exempt participant.
Redlands is
by no means the final chapter in the evolution of the law in this
area. The decision will likely be appealed, and in the meantime
it raises as many questions as it answers. Redlands reinforces the
most basic rule of joint ventures between nonprofits and for-profits:
careful advance planning and drafting is essential to avoid jeopardizing
exemption or producing unrelated business income.
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