Approximately half of the community hospitals in the United States are not-for-profit organizations. These hospitals have also elected to operate exclusively for charitable purposes, having secured substantial tax benefits by being recognized accordingly as tax-exempt under Internal Revenue Code section 501(c)(3). In this article, attorneys Carlene Y. Lowry and Craig R. McPike of the law firm Snell & Wilmer in Phoenix discuss special joint venture topics pertaining to not-for-profit charitable organizations.
To be tax-exempt as a charitable organization under section 501(c)(3), an organization must be organized and operated exclusively for one or more qualifying charitable purposes, and none of its earnings may inure to any private shareholder or individual. The promotion of health is recognized by the Internal Revenue Service (IRS) as a qualifying charitable purpose. Some academic medical centers also further the charitable purpose of education.
Not-for-profit (NFP) organizations cannot be owned by individuals. Once established, the NFP organization may be governed by officers and a board of directors, but no individuals have an ownership claim on the profits of the organization.
Charitable NFP hospitals and health systems commonly own for-profit subsidiary businesses and invest in for-profit joint ventures as a method of obtaining additional revenue. These for-profit subsidiaries and joint ventures may or may not further the parent organizations’ charitable purposes. Whether charitable purposes are furthered through the arrangement, and the extent of the parent NFP organization’s risk tolerance, are two primary considerations that will inform the appropriate structure for such endeavors.
Carlene Lowry, an attorney with Snell & Wilmer in Phoenix, says that, if a charitable organization invests directly in a joint venture taxed as a partnership, the activities of the joint venture are attributed to the charitable organization. As a consequence, the charitable organization must be able to control the activities of the joint venture that relate to the parent organization’s charitable status.
“The issue of control becomes very important in these joint ventures,” says Carlene Lowry. “If a charitable organization enters directly into a partnership joint venture with a for-profit entity, the authorities are clear that the charitable organization must be able to control the joint venture from the perspective of furthering the charitable organization’s tax-exempt mission.”
According to fellow Snell & Wilmer attorney Craig R. McPike, there are also options for structuring NFP investments in for-profit joint ventures when it is known that a charitable organization partner will not have control or reserve powers, or will engage in unrelated activities primarily for revenue-generating purposes. If the proposed joint venture is expected to engage in activities with purposes unrelated to the charitable organization’s mission, a C-corporation subsidiary may be used as investment vehicle for the charitable organization.
This is true regardless of whether the joint venture entity is a C Corporation or if the C Corporation is used by the charitable organization to invest in a joint venture partnership. “If a charitable organization plans to invest in a joint venture partnership that is engaging in activities unrelated to the organization’s charitable mission, the organization may create a subsidiary corporation, typically referred to as a C-blocker, to block the joint venture’s (non-exempt) activities from being attributed to the charitable organization.”
Lowry and McPike say the decision for a charity to invest in a for-profit joint venture directly or through a C-blocker subsidiary should depend upon the activities to be engaged in by the joint venture and the control that the charitable organization would be able to exercise over those activities. Lowry and McPike also point out that majority ownership does not necessarily mean control. Similarly, majority ownership may not be necessary for the type of control needed for such ventures. The operating agreement of a joint venture partnership can carve out absolute powers, controls, and authority to a charity even if it does not own 51% of the joint venture.
Lowry adds, “The charitable organization should also consider negotiating for the right to exit or terminate the LLC arrangement if continued involvement would endanger its tax-exempt status.”
For-profit joint ventures between charitable organizations, including hospitals, and other parties can also raise concerns pertaining to “excess benefit transactions”. The IRS precludes individuals with the ability to exert substantial influence over the affairs of a 501(c)(3) public charity, as well as persons closely related to such individuals (collectively called “disqualified persons”), from benefiting unfairly or unreasonably with respect to the charity.
It is important to review the entire deal for potential excess benefit transactions, as they can arise through third-party compensation or other contracts in addition to the main joint venture arrangement. McPike states, “Any side agreements taking place should be at arm’s length as well, and should be reviewed in conjunction with the main agreement.”
Overall, structuring and negotiating a joint venture between a charitable organization and a for-profit “takes diligence, digging in, asking questions and understanding the facts at each layer,” says McPike.