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New IRS Ruling on Non Profit Participation in Partnerships

Today, many charitable nonprofit organizations are interested in entering into partnerships or joint ventures with for profit companies. Such for profit companies may have expertise that the nonprofit organization does not, and the nonprofit company may believe that such a partnership will help it to better succeed in meeting its mission. Often, the partnership is for only limited purposes and the nonprofit organization does not control the joint venture. Until recently, the tax consequences of such ancillary joint ventures were uncertain. In a recent Revenue Ruling (2004-51, 2004-22 I.R.B. 974) the Internal Revenue Service has added some clarity to this area of the law.

Prior to the issuance of this ruling, the Internal Revenue Service had issued only a Revenue Ruling concerning whole hospital joint ventures (Revenue Ruling 98-15). The ruling considered whether a charitable organization that operates a hospital continues to qualify as tax-exempt when it forms a limited liability company with a for-profit company and contributes its hospital and all of its operating assets to the limited liability company, which company then operates the hospital. The ruling generally held that a charitable organization may form and participate in a joint venture or partnership without adverse effect on its tax-exempt status if (i) a charitable purpose is furthered by the charity’s participation in the partnership, and (ii) the partnership permits the charity to act exclusively in furtherance of its charitable purposes and only incidentally for the benefit of its for profit partners. The ruling considered two different factual situations, one in which the operation of the joint venture adversely affected the charity’s tax-exempt status and one in which it did not. Factors critical to the Service’s determination whether the joint venture had an adverse effect upon tax-exempt status were (i) whether there was a binding obligation on the joint venture to serve charitable purposes, and (ii) whether the charitable organization had voting control over the joint venture. Following this Ruling, it was uncertain what the Internal Revenue Service would require of a joint venture where only a small portion of a charity’s activities are placed in the joint venture.

In Revenue Ruling 2004-51, a university that had been recognized as a charitable tax-exempt organization under Code Section 501(c)(3) formed a limited liability company with a for-profit company to offer teacher training seminars at off-campus locations using interactive video technology. The for-profit company specialized in conducting interactive video training programs. The limited liability company allowed the university to expand the reach of its teacher training seminars. The university and the video company each held a 50 percent interest in the limited liability company. The video company was responsible for all aspects of the video teacher training seminars including advertising, enrolling participants, arranging for facilities, and distributing materials. The university had the exclusive right to approve the curriculum, training materials and instructors and to determine the standards for successful completion of the seminars. All other actions required the mutual consent of both parties. Any contracts and transactions entered into by the limited liability company were required to be at arms’ length and fair market value. The university’s participation in the limited liability company was an insubstantial part of its activities.

For purposes of determining an organization’s exempt status, the activities of a partnership or a limited liability company taxed as a partnership are deemed to be the activities of its partners or members. Generally, an exempt organization may participate in a partnership if such participation furthers a charitable purpose and permits the organization to act exclusively in furtherance of its exempt purpose and only incidentally to benefit its for-profit partners.

Here, the Internal Revenue Service ruled that the activities of the limited liability company were attributed to the university to determine whether it would continue to qualify for tax-exempt status and whether it was engaged in an unrelated trade or business. Under the facts of the ruling, because the participation of the university was an insubstantial part of its activities, such participation, taken alone, did not adversely affect the university’s continued qualification for tax-exempt status.

Importantly, the Service further ruled that because the university’s activities conducted through the limited liability company were substantially related to its exempt purposes and function, the university did not have unrelated business income. Critical to this conclusion was the fact the university had sole authority to approve the curriculum, training materials and instructors, as well as the authority to determine the standards for successful completion of seminars. In addition, all contracts and transactions entered into by the company were to be at arms’ length and each member of the limited liability company had interests and received distributions proportional to its capital contribution. Although the video company arranged and conducted the seminars, this did not adversely affect the conclusions of the Service because the seminars were nonetheless related to the university’s educational purposes.

Thus, under the appropriate circumstances, a tax-exempt charitable organization may retain its tax-exempt status and further its charitable purposes by membership in an ancillary partnership even if it does not have control over the partnership. Relevant factors include: (i) whether the activities of a partnership further the charitable purposes of the exempt organization, (ii) whether the exempt partner retains control over aspects of the partnership inherent to its charitable purposes, (iii) whether all transactions entered into by the partnership are at arm’s length and fair market value, and (iv) whether each partner’s interests and distributions are proportional to his contributions to the partnership.

For more information regarding this article or other Nonprofit Legal issues, please contact Pearl Doherty at 919.783.2958 or by email at pbdoherty@poynerspruill.com.

This electronic publication is published by Poyner & Spruill LLP to provide general information about significant legal developments. Because the facts in each situation vary, the legal precedents noted herein may not be applicable to individual circumstances. Copyright 2004.