Greenberg Traurig Alert

IRS Wins Joint Venture Case;
Tax Court Finds Rental Payments Were Royalties

July 1999
By Harry J. Friedman, Greenberg Traurig, Miami Office

  View or download the PDF version of this Alert here.

Revenue Ruling 98-15 Upheld

In a much anticipated decision in the Redlands Surgical Services v. Commissioner case, the Tax Court upheld the denial by the IRS of tax exempt status to Redlands Surgical Services ("RSS"), a nonprofit healthcare corporation. The Redlands case tested the position of the IRS that tax exempt status was not available where the applicant’s sole purpose was to act as a general partner in a partnership of which the applicant had no effective control of the activities. The Court concluded that RSS was not operated exclusively for charitable purposes. The IRS had enunciated this position in Revenue Ruling 98-15, issued in March 1998. Revenue Ruling 98-15 addressed the consequences of an exempt organization participating in a "whole hospital joint venture." In Redlands, the IRS applied the same test to an ancillary joint venture.

Although the decision addresses the exempt status of a health care provider, it clearly will have far wider impact. The rationale will apply to joint ventures involving non-health care exempt organizations. In addition, the analysis that led to the Court’s decision may also be applicable to situations where the issue is not the exempt status of the organization, but rather the treatment of income allocated to an exempt partner from a partnership as unrelated trade or business income.

RSS is a corporate subsidiary of Redlands Health Systems ("RHS"). RHS is the parent of a corporation that operates a nonprofit hospital. The hospital wanted to increase its outpatient surgery capacity. RHS entered into an agreement with a for-profit entity that operates ambulatory surgical centers. The two formed a general partnership ("GP") for the purpose of acquiring an interest in an existing surgical center. RSS was formed by RHS solely for the purpose of acquiring the interest of RHS in GP. RSS has no other activities.

GP acquired a 61% interest in the operating partnership. GP is the sole general partner of the operating partnership. Most of the limited partners of the operating partnership are physicians. A subsidiary of the for-profit corporation manages the center’s day-to-day operations.

GP’s agreement provides for a management committee consisting of four persons, two were appointed by the for-profit entity and two were appointed by RSS. In the event of a disagreement, either partner was entitled to institute an arbitration procedure to resolve the matter. The agreement also contained a noncompete agreement precluding either party or RHS from competing with the center during the term of the agreement and for two years thereafter.

The IRS argued that RSS had ceded effective control over its sole activity, the surgical center, to a for-profit partner and the for-profit management company. The ceding of control of the partnerships and the surgery center’s activities to for-profit parties, according to the Tax Court, conferred on those parties significant private benefits. Accordingly, the Tax Court found that RSS was not operating exclusively for charitable purposes, a requirement to obtain status as a tax exempt charitable organization. The Court rejected RSS’s argument that the critical issue was the conduct of the organization rather than control. The Tax Court concluded that merely the ability to block action by the for-profit partner action was not sufficient to establish that the organization had effective control over the manner in which the partnership conducted activities. RSS lacked the formal control to respond to community needs. The absence of any control, coupled with a management contract to which the operating partnership bound, evidenced an inability to require that the partnership be operated for charitable activities. The for-profit parties had no express or implied obligation to put the charitable objectives of RSS ahead of noncharitable, profit-making objectives of the for-profit entities.

The Tax Court also noted the market advantages and competitive benefits that were secured by affiliates of the for-profit entities as a result of the arrangement.

In Revenue Ruling 98-15, the IRS addressed whole hospital joint ventures joint ventures where a tax exempt hospital contributes all of its assets to a joint venture with a for-profit operator. The Revenue Ruling discussed good and bad examples. The good example (the organization could retain its exempt status) required that the tax exempt organization have effective control over the operation of the hospital and the absence of a management agreement with any affiliate of the for-profit entity. The Redlands case is consistent with the rationale of Revenue Ruling 98-15, mandating control of the activities of the partnership in order for the nonprofit partner to be entitled to tax exempt status.

The agreements involved in the Redlands case did not contain any express requirement that the partnership operate for charitable purposes rather than to maximize profits. RSS could not require the partnerships to act for charitable purposes. It is possible that the absence of control could have been mooted if the agreements provided that charitable purposes must be given priority in decision making. In addition, the absence of charity care was cited by the Tax Court as evidence of a lack of charitable purposes. A situation where the partnership engaged in substantial charity care might also support a contrary result.

Beyond the exempt status situation, the Redlands case may also bear consideration with respect to unrelated trade or business income tax issues ("UBIT"). Often a tax exempt organization that has a number of exempt activities, for example, a tax exempt hospital, will enter into a joint venture with a for-profit entity to provide a particular ancillary service. Similar facts to the Redlands case may be presented by a hospital that otherwise has substantial exempt purpose revenues. Assuming that the revenues of the joint venture allocable to the hospital are not substantial in relation to the hospital’s other revenues, the mere fact that the hospital does not control the partnership would not likely endanger the exempt status of the hospital. However, based on the Redlands case, the IRS may conclude that the activities of the partnership are not related to the exempt purpose of the hospital, therefore, the income allocable to the hospital from the partnership should be treated as UBIT.

In light of this ruling, exempt organizations should review all of the joint ventures or partnerships in which they participate. Counsel for RSS has indicated that RSS will appeal this decision to the Court of Appeals.

Rental Income from Mailing Lists

The Tax Court has once again rejected an IRS determination that an exempt organization’s mailing list rental income constitutes an unrelated trade or business. Two cases were recently decided involving Common Cause (a Section 501(c)(4) organization) and Planned Parenthood (an organization described in Section 501(c)(3)). The facts in the two cases were similar.

Common Cause had retained two companies, without written contracts, to promote and facilitate rental transactions of its mailing lists. The two companies incurred promoting and marketing expenses, but did not charge Common Cause additional fees. The lessee of the mailing lists provided direct compensation to Common Cause for the use of the list. In addition, the lessee paid commissions to two companies for promoting the list, as well as to a third company for brokering the mailing list.

Generally, income earned by an organization that constitute royalties, payments for the use of intangible property, such as mailing lists, are not subject to tax as unrelated trade or business income. However, since a royalty is by definition passive income, income that constitutes compensation for services rendered by the owner of the property cannot be a royalty. The IRS took the position that the mailing list activities constituted an unrelated trade or business because the two companies acting to promote and facilitate rental transactions were agents of Common Cause.

The Tax Court in Common Cause stated that it needed to decide whether a portion of the rental payments constituted compensation to Common Cause for goods or services. The Court concluded that all of the activities, other than certain list brokerage activities which were not attributable to Common Cause, were royalty-related activities because they were undertaken merely to exploit or protect the mailing list and were not services performed on behalf of another party. Promoting and marketing the mailing lists were royalty-related activities.

In the two cases involving Common Cause and Planned Parenthood, the IRS continues with its string of losses in trying to assert that payments to exempt organizations for the use of intangible property constitute taxable income. The IRS has also unsuccessfully challenged income earned by exempt organizations from affinity credit card programs. These recent cases indicate that exempt organizations can be compensated for the use of their intangible property. However, close scrutiny must be made of these transactions to insure no services are being provided as part of the transaction.

© 1999 Greenberg Traurig