On March 4, 1998, the IRS released Rev. Rul. 98-15, the much anticipated Revenue Ruling considering whole hospital joint ventures between an exempt hospital and a for-profit partner. Although the ruling specifically deals with hospitals and health care issues, it will have broad implications for any joint venture between an exempt organization and a for-profit partner. Every exempt organization, particularly if exempt under section 501(c)(3) of the Internal Revenue Code of 1986 (the "Code"), should review its current joint venture arrangements and analyze future joint venture proposals in light of the holdings and discussion in this ruling.
The ruling analyzes two joint venture situations. In both cases, an organization that operates an acute care hospital and is exempt under section 501(c)(3) of the Code forms a limited liability company with a for-profit corporation joint venturer. The limited liability company is treated as a partnership for federal income tax purposes. The exempt organization contributes its hospital and other operating assets to the limited liability company and the for-profit corporation contributes other assets. The exempt organization will use the distributions from the venture to make grants to support health care in the community. The facts in each situation differ with respect to certain aspects concerning the venture, particularly control and operation of the joint venture and management arrangements. Based on the facts of each situation, the first organization was found to continue to be exempt under section 501(c)(3) of the Code while the second organization was held not to be operated for exempt purposes. It is important to note that, since the entire hospital operations were contributed to the venture, the exempt organization essentially had no activities unrelated to the joint venture.
In analyzing each situation, the IRS set forth the legal standards for evaluating the joint venture. An exempt organization will retain its exemption only if it is operated exclusively for exempt purposes. In determining whether this standard is met in a joint venture arrangement, the IRS first stated that the activities of an entity treated as a partnership for federal income tax purposes, regardless of whether the entity is formed as a limited liability company, partnership, or some other vehicle for state law purposes, will be considered to be the activities of the exempt owner for purposes of determining whether the activities of the exempt organization further exempt purposes. That is, the exempt organization is deemed to undertake the activities of the joint venture. The IRS then set forth a two-prong test for determining whether participation in a joint venture would be deemed to further exempt purposes: (1) the operations of the joint venture must further an exempt purpose, and (2) the arrangement must permit the exempt organization to act exclusively in furtherance of its exempt purposes and only incidentally for the benefit of the for-profit joint venturer.
The IRS focused on four facts to conclude that participation by the first hospital in a joint venture met the two-prong test and did not adversely affect its exempt status:
First, the exempt hospital and the for-profit corporation each received an ownership interest proportional and equal to its respective contribution, and the governing documents of the venture provided that all returns of capital and distributions of earnings would be proportional to ownership interests. In other words, each party paid fair market value for its interest in the venture and received a return based on its contribution.
Second, the governing documents of the venture provided that the exempt organization could appoint a majority of the governing board of the venture and further provided that a majority was necessary to approve major decisions, including annual capital and operating budgets, distributions of earnings, selection of key executives, acquisition and disposition of operating facilities, contracts in excess of a certain amount, changes to the types of services provided, and renewal or termination of management agreements.
Third, the governing documents required the joint venture to further exempt purposes by promoting health for a broad cross section of the community and specifically provided that furthering exempt health care purposes would override any duty to operate for the financial benefit of its owners. The actual operations of the joint venture were essentially required to be in accordance with section 501(c)(3) of the Code.
Fourth, none of the officers, directors, or key employees of the hospital were promised employment with the joint venture or given any inducements to approve the joint venture. In addition, neither they nor related individuals or entities had any interest in the for-profit corporation joint venturer.
Thus, the first hospital’s participation in the joint venture was found to be in furtherance of its exempt health care purposes.
In the second situation, the hospital received an ownership interest based on its contribution. There were, however, two significant differences in the venture’s organization and operations. The exempt organization only appointed three members of a six-member board and, therefore, it could not control the joint venture. Without control, it could not ensure that the venture’s activities were in furtherance of exempt purposes and did not benefit private parties. Although the exempt organization did not control the venture, it did have veto rights over certain decisions, including the annual capital and operating budget, distributions over a required minimum, unusually large contracts, and the selection of key executives, but veto rights were not sufficient. Further, the governing documents did not require the joint venture to operate the hospital in a manner that furthered charitable purposes or benefited the community. The fourth criterion was not specifically addressed with respect to the second situation. The exempt organization, however, agreed as part of the formation of the venture to approve the selection of two individuals who had previously worked with the for-profit corporation to be the venture’s chief executive officer and chief financial officer. Based on these facts, the IRS ruled that the operations of the joint venture did not satisfy the two-prong test for participation in a joint venture by an exempt organization. An exempt organization involved in a significant joint venture vis-à-vis its overall activities will jeopardize its exemption if (1) it does not receive a fair market interest in the venture and (2) it does not have sufficient control to ensure that the venture operates to further its exempt purposes.
The ruling also provides guidance with respect to management arrangements for a joint venture. The ruling states that a joint venture having an exempt owner may enter into a management contract with a private party giving that party authority to conduct activities on behalf of the venture and direct the use of the venture’s assets without adversely affecting the exempt status of the exempt owner, provided that (1) the venture retains ultimate authority over its assets and operations, and (2) the terms of the contract are reasonable, including reasonable compensation and a reasonable term. In the first situation in the ruling, the management agreement was acceptable because (1) the management company was unrelated to the for-profit corporation, (2) the agreement was renewable every five years by mutual consent, and (3) the terms and conditions of the management agreement were otherwise reasonable and comparable to other management contracts in the industry. In the second situation, the IRS was critical of the management arrangement, even though the terms and conditions, other than the renewal provisions, were comparable to those in the industry, because (1) the management company was a wholly-owned subsidiary of the for-profit joint venturer, and (2) the agreement was renewable for five year terms at the discretion of the management company only. In addition, the chief executive officer and chief financial officer of the venture had been affiliated with the for-profit corporation, with the result that the for-profit corporation would have significant authority over day-to-day operations.
Although the ruling sets forth all of the facts together and does not separately analyze the structure of the venture and the terms of the management agreement, it appears, based on the analysis of the ruling, that both issues have independent significance. That is, an exempt organization would jeopardize its exemption if it entered into a joint venture that did not meet the two-prong test above or if it met those tests but the joint venture entered into a management agreement that did not meet the management agreement standard set forth above.
Since the fact patterns in the ruling have several differences under the various tests, it is unclear whether all facts are relevant or whether an organization could diverge in some respects without adversely affecting its exemption. Exempt organizations must wait for additional interpretive authority to know exactly where the lines are and what variations are possible. For example, it would appear that the ruling would only be applicable when the operations of the venture are significant vis-à-vis the exempt organization’s overall activities. In the ruling, the exempt organization’s revenue was generated solely from the joint venture. If the venture is not significant in terms of revenue and operations and does not satisfy the requirements of the ruling, it may be that the revenue from the venture would be classified as unrelated business taxable income but that the organization would not jeopardize its exemption. These are issues that need to be fleshed out in the future.
A final holding of the ruling will have significance with respect to an organization’s public charity status. In the ruling, the hospital organization transfers all of its operations to the venture and its operations in the future will consist solely of making grants for health care purposes from its distributions from the venture. It will have no direct hospital activities. The ruling nonetheless holds that the organization will continue to qualify as a public charity, rather than a private foundation, based on the activities of the venture. In other words, the activities of the venture are attributed to the exempt organization owner not only for purposes of determining whether its activities are exempt but also for purposes of determining whether it qualifies as a public charity. Since public charity status is far preferable to private foundation status and there was concern that the activities of the venture would not be attributed to the exempt owner for this purpose, the ruling should provide significant flexibility for exempt organizations involved in joint ventures.
A Revenue Ruling is the IRS’s interpretation of current law, and thus, the ruling is effective for existing as well as future joint ventures and management agreements (with or without a joint venture). Unlike new statutory or regulatory provisions, there is no prospective effective date. Exempt organizations involved in joint ventures or management agreements with for-profit entities or individuals should review the structure of the arrangements in light of the ruling to determine whether changes would be appropriate.