By Laura Kalick, JD, LLM and David Friend, MD
Joint ventures between nonprofit and for-profit entities are very popular these days, especially in the healthcare arena,
where nonprofits are hungry for access to new sources of capital to fund efforts that will give them a competitive advantage in a rapidly changing environment.
While joint ventures between nonprofit and for-profit entities aren’t a new concept, the rules have changed over the years. Initially, the Internal Revenue Service (IRS) opposed arrangements in which the exempt organization acted as the general partner of the arrangement, since it subjected the assets of the organization to the claims and creditors of the partnership. As the industry has evolved, so has the IRS’ position: Now, the exempt organization can be a general partner, so long as the partnership furthers its purpose and there are effective controls to protect its assets.
Whether the joint arrangement is through a partnership, limited liability company or management contract, the general
financial considerations remain the same. The key issues to consider with joint venture arrangements include:
Does the transaction make sense from a business and economic perspective? Simply seeking to perform a tax arbitrage will not yield a satisfactory result.
Proper income treatment
Joint ventures taxed as partnerships are “passthrough” entities. This means the venture is taxed as if the exempt organization entered into the venture directly. Securing favorable tax status for the venture weighs heavily on not only “what” the venture is doing, but “how” it is being done. The key question to ask: Would the venture be considered an unrelated trade or business if the exempt organization operated it directly? If so, it would create unrelated business income if operated through a joint venture.
In order to avoid unrelated business income taxes, there must be documents and evidence to suggest that the venture is operated in a manner that is consistent with the nonprofit’s purposes. Thus, the exempt organization must maintain sufficient control over the venture to ensure it is run in a manner that prioritizes the exempt organization’s purposes over profitmaking objectives. If the exempt organization does not have an interest large enough to exercise control, other safeguards should be implemented, such as super majorities required for certain actions or veto powers.
If one of the exempt partners happens to be a hospital, the hospital must be able to ensure that the venture’s activity will be conducted to further the community’s benefit. Otherwise, the income stream could create unrelated business income. Furthermore, if the joint venture partner is involved in a hospital department’s operation, the hospital’s section 501(r) financial assistance policy and billing and collection policies must still cover the department to avoid creating tax issues that would cause revenue to be treated as unrelated business income.
Quid pro quo funding
The exempt organization’s share of profits and losses from the venture must be proportionate to its contribution to avoid tax issues, such as private inurement.
Buying, leasing and lending
In some cases, the exempt organization may lease or sell property to the joint venture, or buy or lease property from the for-profit entity. In either case, the transaction must be transparent and for fair market value. This also holds true for loans and guarantees.
Intermediate Sanctions rules could apply if transactions are not at fair market value and if the for-profit entity is one that can exercise substantial influence over the organization. Whether a party can exercise substantial influence over an exempt organization must be determined through a facts and circumstances analysis. For cases in which the joint venture is with physicians, their previous relationships with a hospital, including how many patients their practices admitted, may factor into the analysis.
Organizations can proactively work to prevent the levying of Intermediate Sanctions by establishing the rebuttable presumption of reasonableness when negotiating lease or sales arrangements. This shifts the burden of proof to the IRS to show that the amount involved is excessive. An independent governing body can establish the presumption by approving the transaction based on comparable data and then documenting its decision contemporaneously. Appraisals are always useful in establishing fair market value.
New ventures usually present an opportunity to enter into new compensation arrangements that appropriately reward the players. Again, the fair market value standard reigns supreme here.
The IRS is highly concerned about protecting the assets and activities of nonprofit organizations in these arrangements, so the venture’s business terms should provide details of the protective measures in place. For example, if the business venture is liquidated, will the exempt organization still be able to serve its population? Is a non-compete clause too onerous? The assets contributed by the exempt organization should be adequately insured by the new venture.
Use of tax-exempt bonds
If a venture leases property from an exempt organization whose property is financed with tax-exempt bonds it may be considered a “private business use,” creating taxable interest on the bonds if certain thresholds are met. For Accountable Care Organizations (ACOs), the IRS expanded its 1997 safe harbor, which states that ACOs using property financed with tax-exempt bonds will not be considered a private business use. Paramount in the criteria is that the economic benefits participants receive are proportional to their contributions, and all arrangements with the parties are at fair market value.
New combinations of tax-exempt organizations and for-profit entities often involve a management contract. These contracts should be structured carefully for bond-financed facilities, paying special attention to “qualified use,” which can affect the tax-exempt status of the bonds. The IRS also expanded its 1997 safe harbor as to what provisions of a management contract will allow it to be considered qualified use. The new provision allows the manager to be paid an annual productivity reward, in addition to other compensation, if the reward is based upon the quality of services provided under the contract, rather than increases in revenues or decreases in expenses of the facility. The amount of the productivity award must also meet certain criteria.
It is likely that in the not-too-distant future, there will be increasing combinations of for-profit and nonprofit corporate structures as organizations look to access capital and management talent. In order for these arrangements to be successful, organizations must lay considerable tax, business and governance groundwork to ensure efficiency and tax effectiveness.
For more information contact a Templeton Advisor.
This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Winter 2014). Copyright © 2014 BDO USA, LLP. All rights reserved. www.bdo.com