IRS Wins Redlands Case: Joint Venture with For-Profit Disqualifies Nonprofit for Tax Exemption
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 percent profits interest and controlled 50 percent of the board of a general partnership. A for-profit entity owned the remaining 54 percent profits interest and controlled the other 50 percent of the board. The general partnership, in turn, owned a 59 percent 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 percent 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 percent 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.