CHAPTER 4
Overview: Joint Ventures Involving Exempt Organizations
§ 4.1 INTRODUCTION
p. 294. Insert the following at the end of this section:
The use of joint ventures by charities are becoming critical in view of the recent tax legislation:
- Reduction in tax rates, especially C corp rates to 21 percent (permanent). C corps have been the largest investor in low-income housing tax credits and new market tax credits.
- Increase in standard deduction and reduction in individual rates.
- Significant estate tax relief through doubling of exemption.
- Estimated $1.45 trillion cost for 10-year period of tax reform.
- Limit on or elimination of certain itemized deductions.
- All of which will affect charitable giving and therefore make joint ventures even more attractive as a fundraising device.
However, the 2017 Tax Act (Pub. L. No. 115-97) has retained the low-income housing tax credit, and the new market tax credit was not repealed.
Moreover, charities are likely to receive even less support from budget-constrained governmental agencies and contributions from the private sector. As a result of so many natural disasters, charities have needed to develop new avenues and structures to attract partners to conduct their programs. Not often enough, nonprofits have joined forces to accomplish fundraising or program-related goals. Increasingly, nonprofits of all sorts are forging partnerships and other co-investment relationships with for-profit entities to access otherwise unavailable capabilities, capital, and resources.
§ 4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
(d) The Two-Prong Test: IRS Adopts Plumstead Theatre Doctrine
(ii) Application of the Two-Prong Analysis. p. 309. Insert the following at the end of footnote 76:
Low-income housing project, which was run by LLC and whose activities would be attributed to EO/private foundation, met Rev. Proc. 96-32, 1996-1 CB 717 safe harbor requirements and would continue to do so after EO's acquisition of all LLC membership interests, where activities furthered its Code § 501(c)(3) charitable purpose of providing affordable housing for those of low and moderate income. PLR 201603032, January 15, 2016.
(h) A Road Map
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In order to overcome certain negotiating challenges, it is important for counsel of the charity to educate the for-profit organization's representatives regarding structural issues, control factors, bond covenants, and private benefit limitations. This is because often the for-profit counsel is not knowledgeable as to the reasons why the tax-exempt organization is required to structure a transaction to meet the IRS guidelines under Rev. Ruls. 98-15 and 2004-51 and the case law, including St. David's regarding the “control” factors. Understanding the significance of these relevant factors will facilitate negotiations and the structuring of the venture.
(ii) Unfavorable Factors. p. 357. Insert the following before the Note:
It is critical for the tax-exempt organization to negotiate an exit strategy at the initial phase in the structuring of the transaction so that there isn't impermissible private benefit at the back end in the event that the nonprofit board determines that the transaction has failed and it needs to unwind. Accordingly, language should be provided to allow for reasonable and comparable terms as to an “exit strategy” option, which needs to be retained by the charity.
The mechanics of the unwind and the term need to be set out in the operating agreement. It would include the potential use of a third-party appraisal to validate costs of the unwind, a period during which the unwind can be initiated, say at least five years, along with indemnification provisions and virtual releases. Finally, the charity should retain a power to initiate and expand exempt activities, including mediation or even binding arbitration as part of the exit strategy.
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Recent IRS PLR 201744019. A general acute care hospital was founded as a community hospital; it was operated by § 501(c)(3) hospital system when it applied for tax exemption. Years later, management of the hospital was turned over to a for-profit organization. The agreement with the for-profit required the hospital to provide charity care as previously rendered with no enforcement mechanism. The hospital reported changes on Form 990 annually but did not seek a ruling that its operations continued to be consistent with 501(c)(3) purposes.
On analysis of relationship between the 501(c)(3) hospital and the for-profit entity using the control criteria of Rev. Rul. 98-15 and similar precedents, the IRS determined that the hospital was not operated exclusively for 501(c)(3) purposes because it allowed a for-profit organization to have complete “control” over its operations and did not “exercise adequate discretion and control as required by IRC 501(c)(3).” This language implies that the control criteria of Rev. Rul. 98-15 is embedded in IRC 501(c)(3) as if it were in the regulations or statute itself.
The IRS also ruled that although the 501(c)(3) provided information on its Forms 990s and did not omit or misstate a material fact, it operated in a manner “materially” different from that which was originally represented in its application. The organization “did not formally notify the Service of the changes in activities, nor did it seek an affirmation letter or private letter ruling to confirm that it continued to qualify for exemption.”
In other words, the Form 990 disclosure was not enough.
The PLR confirms that:
- Rev. Proc. 98-15 is alive and well;
- It is a facts and circumstances determination; and
- The 990 disclosure of operational changes does not mean that the IRS has sanctioned any changes. If an organization doesn't seek a ruling regarding continued exemption, any prior Form 990 disclosure is insufficient.
We therefore now have to inform our clients not only about the importance of Form 990 disclosure and evaluate whether—and at what point in time—they should apply for a ruling as to continued exemption.
§ 4.6 REVENUE RULING 2004-51 AND ANCILLARY JOINT VENTURES
(c) Factual Scenarios 1 through 4: Joint Venture Is a “Substantially Related” Charitable Activity (See Exhibit 4.1)
3. Scenario 3: p. 380. Insert the following footnote at the end of this scenario:
228.1See subsections 6.5(a) and 10.4(a).
§ 4.9 CONVERSIONS FROM EXEMPT TO FOR-PROFIT AND FROM FOR-PROFIT TO EXEMPT ENTITIES
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282See subsection 2.10(c), Strategies in the Event of a Proposed Revocation of § 501(c)(3) status, for a discussion of procedures involving conversions from one provision of § 501(c) to another after revocation of exemption on conclusion of an audit.
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§ 4.10 ANALYSIS OF A VIRTUAL JOINT VENTURE
In view of the extensive reach of the IRS published Rev. Rul. 2004-51 as applicable to ancillary joint ventures, this commentator believes that the rationale should apply in a case in which the IRS proposes revocation of an existing § 501(c)(3) organization, alleging impermissible private benefit following an examination of its relationship with a for-profit entity (notwithstanding the fact that no formal joint venture agreement exists between the parties).
Assume a hypothetical case in which an educational or scientific property, such as a magazine or journal, is owned 100 percent by FP, a for-profit business. This magazine attracts and retains members to C, the charity, which provides high-quality educational content related to its charitable goals, including reports of the research supported by FP. FP attracts customers to its business through educational articles and related product placement. The board of C collaborates with FP regarding the educational content of the magazine and oversees the research—in effect, an unconventional “upside down” transaction.
Assume further that the IRS challenges the relationship of the charity and for-profit organization, arguing that there is impermissible private benefit to the FP's business—in effect, that C is operating for substantial nonexempt purpose (i.e., it is acting as a “tool” to enhance the sale of products for FP). This is so, notwithstanding the fact that FP provides significant services and pays all expenses related to the production of the monthly periodical and its health products aid C's members in its charitable mission. The educational articles discussing the health benefits of its products, many of which are cutting edge and difficult to find, are followed by product information providing readers with the information necessary to be able to purchase the products for their own use. Some of the advertisements, in essence, produce a summary of the educational article that immediately precedes each advertisement. The advertisements also provide a method for the reader to fulfill C's purpose of helping readers and members extend healthy human life spans.
Even though the magazine is funded and published by FP, the IRS has alleged that the activities of FP in promoting its products in the magazine justify revocation of C's exempt status. Even if the magazine and its advertisements of products are imputed to C, those activities are substantially related to C's exempt purpose, and thus it can be argued, in reliance on Rev. Rul. 2004-51, that there is no justification for revocation. C is operated solely for the exempt purpose of funding scientific research and extending the healthy human life span.
Amounts paid by FP to C are structured to be “reasonable” as determined by independent parties (e.g., royalties, analogous to the facts in Situation 1 of Rev. Rul. 98-15, where management contract fees were deemed reasonable). Royalties are paid by FP to C to be used exclusively to fund research and education.
C retains ownership and control of its name, logo, trademarks, related goodwill, and assets, the use of which are crucial to FP activities; this is analogous to the university retaining ownership of the course curricula and materials in Rev. Rul. 2004-51.
FP donates administrative, accounting, legal, and fundraising information technology to C and performs all marketing functions and sales, analogous to the for-profit partner in Rev. Rul. 2004-51 who handled the administrative/business functions of the venture.
Although there is no formal joint venture structure, C, the § 501(c)(3) organization, should be able to rely on the “bifurcated” control test pursuant to Rev. Rul. 2004-51. This is so even though there is no provision in any agreement dealing with the distribution of net proceeds, but, in fact, substantial royalties are paid by FP to fund C's educational scientific research.