Establishing the Groundwork for Joint Ventures between Nonprofit and For-Profit Organizations

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 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. Several of the key issues to consider with joint venture arrangements include:

1. Economic justification. Does the transaction make sense from a business and economic perspective? Simply seeking to perform a tax arbitrage will not yield a satisfactory result.

2. 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.

3. Asset protection. 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.

4. Proper income treatment.  Joint ventures taxed as partnerships are “pass-through” 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 profit-making 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 qualify revenue as unrelated business income.

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. Stay tuned in the coming weeks for the Winter 2015 Nonprofit Standard newsletter, which will feature the full version of this article, including several additional considerations for organizations to keep in mind surrounding joint venture arrangements.