REVENUE RULING 98-15: OPERATIONAL CONTROL SAVES THE EXEMPTION
By Roy Whitehead, Jr., JD, LLM, associate professor, University of Central Arkansas
The publication of Revenue Ruling 98-15 has provided long-awaited guidance on the tax exemption issues associated with the formation of joint ventures between tax-exempt, nonprofit entities and for-profit companies. The critical, and henceforth largely unresolved, question is under what circumstances may the nonprofit participant retain its tax exemption? The ruling involves whole hospital joint ventures, but its principles are applicable to other comparable joint ventures. A whole hospital joint venture is one in which the tax-exempt partner contributes substantially all its assets to the joint venture in return for a joint venture interest. Meanwhile, the for-profit partner contributes assets and/or cash and receives a joint venture interest. The resulting joint venture operates the hospital, usually pursuant to a management contract with the for-profit partner.
The ruling provides guidance on exemption issues that arise by giving examples of fact patterns that will result in a safe harbor for the tax-exempt participant and by describing a set of facts that will cause a loss of the tax exemption. The instructive fact pattern areas follow:
1. The Safe Harbor. "A" (tax exempt) and "B" (for-profit) constitute a joint venture in the form of an LLC. Pursuant to section 301.7701-3(b) of the Procedure and Administrative Regulations, the LLC is treated as a partnership for tax purposes. A contributes all its assets and B contributes enough assets that each owns 50% percent of the LLC. The governing board consists of three members from A and two from B. The governing documents provide that the board members have a duty to operate the resulting LLC to further the charitable purposes of A. None of the directors, officers, or employees involved in the decision to form the joint venture received any promise of employment or other reward from the for-profit participant or the resulting LLC. The directors appointed by A have no conflicts of interest. Finally, A intends to use the distributions it receives from the LLC to fund grants to support activities that promote community health care.
2. The Loss of Exemption. "D" (tax-exempt) and "E" (for-profit) form an LLC that is structured on a 50/50 basis. The governing board is composed of three representatives from D and three from E. The consent of both parties is required to amend the governing documents. The LLC enters into a management contract with a management company that is an affiliate of E. In addition, the CEO and CFO of the LLC previously worked for E, the for-profit partner.
The ruling says that the question of whether the nonprofit entity will retain the exemption turns on the effect of the joint venture on operational control. The exemption will be retained when the participation by the tax-exempt entity--
* furthers its exempt purpose and
* the joint venture is structured to permit the exempt participant to act in furtherance of its exempt purpose.
The IRS concluded that A will continue to qualify as a section 501(c)(3) entity because A has established that it will be operated for its charitable purpose of community health care and will only incidentally benefit the for-profit entity. A's qualifications are demonstrated by A's control of the governing board, the director's duty to operate the LLC in the interest among A's community health purposes, and the absence of conflicts of interests among A's officers, directors, and key employees. These facts and circumstances establish that A will further its charitable purpose and continue to operate exclusively for exempt purposes.
On the other hand, the IRS concluded that entity D, the nonprofit in the second fact situation, fails to comply with the operational control requirements of 501(c)(3). This is so because D does not maintain control over the LLC board and its operations, the LLC has no duty to carry out D's community health-care functions, the retained management company is an affiliate of the for-profit participant, and the CEO and CFO have a prior relationship with the for-profit partner. Consequently, D cannot establish that it exercises sufficient operational control over the LLC to insure that it is operated exclusively for exempt purposes.
The ruling is consistent with tax court cases that hold that the key factor in deciding whether a tax-exempt entity retains its exemption is the extent of operational control over the charitable assets by the tax-exempt participant [Plumstead Theatre Society v. Commissioner, 74 T.C. 1324 (1980) and Housing Pioneers v. Commissioner, 65 T.C.M. (CCH) 2191 (1993) amended 58 F.3d 401 (1995)]. *
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