GT Alert

Update on Joint Ventures; Guidance on Excess Benefit Transactions

May 2004
By Harry J. Friedman, Greenberg Traurig, Phoenix Office

  View or download the PDF version of this Alert here.

Jury Verdict in the St. David’s Case

Recently, a Federal District Court jury decided that St. David’s Healthcare System should retain its tax-exempt status notwithstanding its whole-hospital joint venture with Columbia/HCA. This jury decision appears to end litigation on the status of St. David’s.

"The control of a joint venture may not only impact on the tax-exempt status of the participants but also may determine whether or not operating income from the joint venture is subject to the unrelated business income tax."

The St. David’s case was the latest judicial examination of the consequences of joint ventures between for-profit and tax-exempt organizations. Because of financial difficulties, St. David’s entered into a partnership agreement with HCA in 1996. St. David’s contributed all of its hospital and medical assets to the partnership. A subsidiary of HCA was the managing partner and the partnership entered into a management agreement with another HCA affiliate. Half of the board of the partnership was appointed by St. David’s and the other half by HCA. The Internal Revenue Service (“Service”) asserted that the partnership with HCA resulted in a private benefit, and consequently, St. David was no longer primarily engaged in a charitable activity. The Service revoked the exempt status of St. David’s.

The District Court in 2002 rejected the Service’s argument concluding that the partnership agreement provided adequate protections that the partnership would be operated for charitable purposes and that the voting rules and rights granted to St. David’s, including St. David’s power to remove the partnership CEO unilaterally, was sufficient to conclude that St. David’s was still operating for charitable purposes. The District Court granted summary judgment to St. David’s.

As expected, the Service appealed the District Court’s decision to the 5th Circuit Court of Appeals. In November 2003, the 5th Circuit reversed the District Court ruling sending the case back to the District Court for further proceedings. The Appeals Court concluded that the case raised issues of material fact that needed to be examined.

The 5th Circuit found that merely the fact that the partnership continued to provide charitable services was not sufficient to sustain St. David’s position. The Court noted that if more than an “insubstantial” amount of the partnership’s activities furthered private interests, then St. David’s would be deemed no longer to be operated exclusively for charitable purposes, a requirement for tax-exempt status. The 5th Circuit focused on the “control issue.” The Court concluded that precedents indicated that when a non-profit organization forms a partnership with a for-profit entity, the non-profit should lose its tax-exempt status if it cedes control to the for-profit entity. The Court concluded that this created an issue of fact since, at best, “St. David’s can prevent the partnership from taking action that might undermine its charitable goal; St. David’s cannot necessarily ensure that the partnership will take new action that furthers its charitable purposes.” The powers that the District Court found sufficient control, including the power to force dissolution of the partnership, was not enough for the 5th Circuit.

The 5th Circuit also adopted Revenue Ruling 98-15 the Service’s position that the partnership agreement must give the non-profit organization a majority vote in order to establish that it has sufficient control over the partnership’s activities.

On March 4, 2004, following a four-day trial, a Federal District Court jury decided that St. David’s should retain its non-profit status. The jury verdict does little to clarify issues, although it does suggest that the choice of forum may be important. The jury verdict may indicate a jury would be more receptive to equitable arguments rather than the Tax Court. It would appear that the jury concluded that the partnership agreement did provide sufficient controls for St. David’s to insure that the partnership operated for charitable purposes.

The control of a joint venture may not only impact on the tax-exempt status of the participants but also may determine whether or not operating income from the joint venture is subject to the unrelated business income tax. The latter frequently will be the issue where the tax-exempt organization has other exempt activities so that the joint venture activity may be “insubstantial.” We believe that it is important to focus on the terms of the joint venture agreement to ensure that the venture operates for charitable purposes. The exempt organization needs more than simply veto power over the activities, but should have the ability to initiate charitable activities. Further, if the exempt organization is concerned that the participation in the joint venture may place its exemption in jeopardy, the use of a taxable subsidiary as its joint venture partner, will avoid loss of exempt status.

Service Releases Guidance on Joint Ventures

Joint ventures between for profit entities and exempt organizations were also the subject of a recent Revenue Ruling. The Ruling posits a university that conducts seminars for teachers forming a limited liability company with a for profit entity that conducts interactive video training. The LLC’s sole purpose is to provide off campus seminars. The exempt university and the for profit each contribute 50% of the capital to the LLC and the profits are split in the same percentages. The governing board is made up of 3 representatives of each. The university has the exclusive right to approve the curriculum and training materials. The for profit entity controls the location of the seminars; other actions require the consent of both members of the LLC. All contracts must be at arms length and for reasonable compensation.

The Ruling concludes that because the LLC’s activities are not a substantial part of the university’s activities, the investment by the university will not affect its exempt status. Further, because the LLC’s activities are related to the exempt purpose of the university, the university’s share of the income will not be treated as taxable income to the university. The Ruling cites the 5th Circuit decision in St. David’s, suggesting its conclusions are consistent with that decision. The control by the university of a portion of the operations seems to have been sufficient to insure that the activity as whole was operated for charitable purposes, even though the for profit entity controlled some aspects of the activity. While it is clear that this does not overrule Revenue Ruling 98-15, it suggests that a 50/50 LLC may be acceptable so long as the exempt organization controls certain aspects of the activity.

Automatic Excess Benefit Transactions

The Service recently issued guidance to its agents on when compensation received by a disqualified person should be considered an “automatic excess benefit transaction” under the Intermediate Sanction rules. (See GT Alert, February 2002, IRS Finalized Intermediate Sanction Regulations, for discussion of the intermediate sanction rules.)

Generally, Intermediate Sanctions impose excise tax penalties on high level executives of charitable organizations who are paid amounts in excess of “reasonable compensation.”

Under the Intermediate Sanction rules, an economic benefit provided to a disqualified person is considered compensation only if the exempt organization providing the benefit clearly indicates an intent to treat the benefit as compensation for services when it was paid. Intent to treat a payment as compensation is clear only if the exempt organization provides written substantiation that is contemporaneous with the transfer of the benefit. If the written contemporaneous substantiation requirement is not satisfied, a revenue agent is instructed to treat the economic benefit as an automatic excess benefit transaction unless the exempt organization can establish that the economic benefit was provided in exchange for consideration other than the performance of services. The automatic excess benefit result is without regard to whether the amount of the payment is reasonable, any other compensation the person may have received is reasonable, or that the aggregate of the economic benefit in any other compensation is reasonable.

Contemporaneous substantiation can be effectuated by including the amount on Form 990, Form W-2 or Form 1099. Substantiation can also be provided if the disqualified person reports the economic benefit on the original Form 1040 filed before the start of a Service examination or the first written documentation by the Service of a potential excess benefit transaction. Automatic excess benefit can also be avoided if the failure to provide written contemporaneous substantiation was due to reasonable cause.

The CPE text also indicates that other written contemporaneous documents may be used to demonstrate that the payment was compensation, such as an employment agreement.

Reimbursement of expenses are disregarded if they are made in compliance with an arrangement that qualifies as a “accountable plan” under Treasury Regulation Section 1.62-2(c)(2), which generally requires submission of receipts by the employee to the organization.

These issues will more likely arise in the context of in-kind payments or the reimbursement of personal expenses by the organization that are not accounted for as compensation. We urge exempt organizations to make sure that all amounts that are intended to be treated as compensation are reported correctly on Form 1099s and W-2s as well as Form 990s. Proper reporting of these amounts will make sure that excess benefit transactions only occur in the face of unreasonable compensation payments.

© 2004 Greenberg Traurig

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