Reporting Joint Ventures on the Form 990

Test your joint ventures to be sure they'll pass muster with the IRS.

Q: Under the governance section in the revised Form 990, why does the IRS ask whether the organization has a joint-venture policy?

A: In the past, the involvement of some exempt organizations with a for profit in a joint venture has led the IRS to conclude that the exempt organization had ceded control to a for profit. This conclusion can lead to unexpected unrelated business income tax (UBIT) or loss of exempt status. A joint-venture policy could help avoid this trouble.

The revised Form 990 (Part VI, Section B) asks these questions:

"16a. Did the organization invest in, contribute assets to, or participate in a joint venture or similar arrangement with a taxable entity during the year?

"16b. If ‘Yes,' has the organization adopted a written policy or procedure requiring the organization to evaluate its participation in joint venture arrangements under applicable federal tax law and taken steps to safeguard the organization's exempt status with respect to such arrangements?"

Meeting the Operational Test

What is the IRS asking in these questions?

Both 501(c)(3) and 501(c)(6) exempt organizations, among others, must meet the "operational test," meaning that an exempt organization must be operating primarily to accomplish its tax-exempt purposes. Conversely, its operations are not to inure to the private benefit of any private persons. Past cases have demonstrated that when an exempt organization joins a for-profit entity in a joint venture to operate programs, the exempt organization can sometimes lose control over its programs, leading to greater emphasis on profit-maximizing purposes than exempt purposes. Two examples:

Redlands Surgical Services v. Commissioners of Internal Revenue Service. An exempt 501(c)(3) hospital's nonprofit subsidiary became a general partner with a for-profit surgical practice. This joint venture operated an ambulatory surgical center through a 15-year contract with a for-profit management company, which was paid a percentage of the surgical center's gross revenues. Five years after the partnership was formed, the number of surgical procedures completed at the exempt hospital decreased by 17 percent but increased by 10 percent at the surgical center. The joint venture's operating agreement contained no statement of charitable purposes, nor did it impose any requirement that it operate for charitable purposes.

The 9th Circuit Court of Appeals supported the IRS' denial of exemption, finding no obligation of the for-profit partner to put charitable objectives ahead of its own profit. The court concluded that the management contract gave the for-profit entity control over day-to-day operations, as well as a profit-maximizing incentive. Weighed together, these factors compelled the conclusion that the exempt organization had ceded control over its operations to a for-profit entity serving private interests more than any exempt public purpose.

St. David's Health Care System v. United States. Control over the joint venture formed to manage the hospital was split 50/50 between the exempt and for-profit entities. The partnership's governing document stated that the exempt hospital could unilaterally fire the CEO and unilaterally dissolve the partnership if it thought things were going awry.

The 5th Circuit Court of Appeals found that this was not sufficient. It found that day-to-day management had been ceded to the for-profit management company—which, by the way, was the subsidiary of the for-profit general partner. The result: Substantial UBIT imposed upon audit.

Defining "Control"

A 1998 revenue ruling left the impression that an exempt organization would have to possess voting control of a joint venture to pass muster. But a 2004 revenue ruling showed that 50/50 voting control might pass IRS muster if the exempt organization retains actual control over the important tax-exempt parts of the operations. In this case, an exempt university formed a 50/50 joint venture with a for-profit video technology company to provide distance-learning programs to teachers. The university retained exclusive power over setting the curriculum, the training materials, naming the instructors, and establishing standards for course completion. The for-profit technology partner had exclusive rights over selecting the technical personnel and the technical interactive video aspects of the seminars. The IRS ruled that the for-profit company was involved in an "insubstantial" part of the activities and that the joint venture was substantially related to the university's exempt purpose of educating teachers.

If your exempt 501(c)(3) or 501(c)(6) organization is involved in or contemplating involvement in a joint venture, be aware of the "ceding control" issue. Consult your attorney to ensure that the IRS won't challenge your exempt status or impose unexpected UBIT.

Mark E. Truesdell is a partner at Beving, Swanson & Forrest, P.C. in Des Moines, Iowa. Email: [email protected]