Nonprofits and Joint Ventures Part Deux: Tax Treatment
As always, when engaging in a new endeavor organizations have to think about their bread and butter; tax exemption status. This is even more important with JV’s, since quite a few sensitive tax issues can crop up and serious consequences suffered if missed. Not holding myself out to be the Gabby Douglas of tax (Go USA!), what follows is a really (really) high level overview of what organizations will want to be thinking about.
The most important thing to understand about joint ventures is that they are treated like partnerships for tax purposes. So the actions, and income, of one partner can count against the other partner as well. Consequently, all income earned during, or through, the joint venture that does not further a charitable purpose counts against an exempt organization and can result in an unrelated business income tax (UBIT).
Some organizations try to avoid this by structuring JV’s in a way that leaves them with a very small or limited interest in the JV. But the IRS has made it clear that this rule applies regardless of the interest an exempt organization has (i.e. whether the organization is a limited or general partner).
Loss of Tax Exemption Status
Exempt organizations in a JV with a for-profit isn’t per se a problem. The key is the arrangement must further an organization’s charitable purpose and failure to do so could result in putting its exempt status at risk.
Where an organization’s exempt status comes into question, the IRS uses a three part test:
- Whether the organization’s participation in the [partnership/JV] serves a charitable purpose.
- Whether the charity, under the particular facts, is insulated from the day to day responsibilities of the JV if it is a general partner.
- Whether or not limited partners are receiving an undue (or unjustified) economic benefit from the partnership/JV.
Other concerns the agency might look at are whether the exempt organization exerts enough control to ensure that the JV doesn’t allow private interests to supersede the charitable. The IRS will also look at agreements entered into between the JV and other parties (i.e. consultants or board members those in the JV bring in) to ensure they are reasonable and comparable to similar situations.
I thought it interesting to point out there are at least 27 different disclosures on the new(er) 990 related to exempt organizations and ventures. So this is something the agency is definitely starting to take an interest in and are monitoring much closer than in year’s past.
The key to avoiding alot of the tax risks with JV’s lies in the governing documents. Whatever documents you use to form the JV, they should clearly require that the JV be operated to further a charitable purpose (remember one non-charitable purpose, even where slight, could put an organization’s status at risk) and the charitable purpose must override any duty to operate for the financial benefit of others.
Note, depending on the state the JV is formed in, requiring that the charitable purpose supersede all other concerns, including profit and private interests, could possibly be a problem if the JV is a corporation. Some might argue that the corporation has a duty to maximize earnings….but this is far more than is necessary today and should be discussed with local counsel.
Secondly, structuring the JV to where the exempt organization has limited to little control does not necessarily have an impact on its liability. Similarly, structuring a JV to where a nonprofit has all the control does not mean the agency will assume all activities are charitable. In fact, there’s been cases where an exempt organization maintained primary control of the JV but still lost its exemption status because the agency found that the nonprofit was simply serving as a shelter. This is especially the case where the court finds the exempt organization is being used as an instrument by a for-profit partner (for more on this Google est. of Hawaii v. Commissioner, 71 T.C. 1067 (1979), aff ’d in unpublished opinion 647 F.2d 170 (9th Cir. 1981)).
Lastly, because the actions of one partner can affect the tax liability of another, organizations will want to ensure that all documentation relating to the JV are kept in accordance with a document retention policy.
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