Greenberg Traurig Alert
IRS Wins Joint Venture Case;
Tax Court Finds Rental Payments Were Royalties
By Harry J. Friedman, Greenberg Traurig, Miami
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
applicants 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
Courts 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 centers
GPs 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
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 centers 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 RSSs 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
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
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 hospitals
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
organizations 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
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
This GT ALERT is issued for informational purposes only and is not intended
to be construed or used as general legal advice. Greenberg Traurig attorneys provide
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